Making Credit Decisions Based on…..air?

| Financial

By Mike Alerding     I have spent the last 25+ years as a volunteer loan committee member of two SBA 504 loan committees and two mezzanine financing organizations. In doing so, I have had the opportunity to look at literally thousands of financial statements from borrowers and potential borrowers from closely-held and usually smaller businesses. I have watched lending professionals approve loans using a variety of information, some of which is actually relevant to the loan itself. I have also had the opportunity to watch lending professionals and the U. S. Small Business Administration (SBA) approve loans using financial information that is non-existent, lacking in relevance or just simply wrong. I am continually amazed at how these loans get approved inside a bank, then by a professional loan committee of an enhancement organization and finally, by the SBA itself.

Banks often accept a borrower’s internal financial statements and, believe it or not, even the borrower’s business income tax return in order to “evaluate” the creditworthiness of the business. Although the lender may be aware that the internal financial statements are not prepared using Generally Accepted Accounting Principles (GAAP) or, for that matter, even on the accrual basis, the lender performs its ritual credit review, faithfully plugging numbers into “spreads” and comparing information to industry standards to highlight anomalies.

Likewise, when a business income tax return is used, whether it is for a corporation, an LLC partnership or even a single member LLC (on Schedule C of the owners’ Form 1040), the lender again is very diligent in performing its lending rituals and reaches a conclusion on the creditworthiness of the deal. The resulting credit analyses look very professional, have all of the necessary boxes filled in and often reach a conclusion that the loan is appropriate and that the business is creditworthy.

Does anyone see anything missing here…….like basic common sense and logic? The information that the lenders use in both of the above scenarios is totally lacking in appropriateness, consistency, completeness and basic logic. Yet, amazingly, lenders are able to make what they believe are “informed” decisions about the creditworthiness of a potential borrower. The crystal ball the banks and the SBA award their lenders after their first training class must be very powerful indeed……

Internal financial statements almost always are prepared using the cash or modified-cash method of accounting – especially those that are prepared as of a month end other than the end of the borrower’s fiscal year. The cash basis and modified-cash basis include financial statements that are missing most assets and liabilities, except for, of course, cash and a few other assets. Accordingly, all leverage, tangible net worth, working capital and other critical financial condition ratios are completely inapplicable to the credit analysis. Further, the lender has no idea whether the borrower has any inventory, accounts receivable, accounts payable or any other working capital assets and liabilities. The only thing the lender usually knows is how much cash is on the balance sheet at the end of the reporting period.

When tax returns are used, things get even further from reality and we now enter the Land of Oz. A business income tax return is a TAX FORM completed to comply with TAX LAWS AND REGULATIONS and, accordingly, has no basis in economic reality. The assets and liabilities listed in a tax return are those assets and liabilities that have been determined using TAX LAW AND REGULATIONS and not basic economic rules and realities. The income statement in a tax return is used to compute TAXABLE INCOME and not net income or earnings as we know it. Taxable income or loss is a “monopoly” or play number that is used solely to determine the amount of income taxes that are due or the amount of earnings losses that are allocated to the owners. It usually bears little or no resemblance to economic reality.

A good example of the absurdity of using tax basis financial statements for credit purposes is the manner in which fixed assets are recorded. Under GAAP, all fixed assets are capitalized and depreciated over each asset’s economic useful life. For tax purposes, however, most fixed assets are never recorded as fixed assets and are simply written off as expense in the year in which they were purchased under Section 179 and other similar tax law provisions. Accordingly, not only are fixed assets understated, but equity is also understated by the same amount. Try and put together a solid financial covenant for Minimum Tangible Net Worth using tax basis financial statements.

To be fair to lenders and to the SBA, other information besides just business financial statements are used to make credit decisions, especially for smaller loans. For example, in many situations, banks are now performing a Global Credit Analysis that takes into account the owners’ personal assets and credit history in making the determination as to the creditworthiness of the business, which makes some sense in many situations. Lenders also use many of the “Lending C’s” which include Character, Collateral, Cashflow, Creditworthiness, etc.

When faced with the absurdity of using information that is inadequate and usually just plain wrong, lenders often point to the SBA as the culprit, reminding me as often as possible that it must be appropriate to use cash basis statements or even tax returns because “the SBA allows it.”  The SBA does a lot of great things for small businesses and I am thankful every day that we have it, but given its history for loan losses over time, I wouldn’t exactly put the SBA at the top of my list as far as determining the most appropriate information to use to evaluate a loan package.

In the final analysis, making credit decisions based on information that is just flat wrong is like using a dart board. If you are an experienced darts player, you generally are successful. If you are a rookie, the results can be devastating. Enron taught the public markets some basic lessons about the importance of using full and fair accounting and disclosure, and I think it is time that the banks, enhancement organizations and the SBA itself got into the 21st Century and begin demanding real economic information from their borrowers in order to make real economic lending decisions.

Mike Alerding is a co-founder and Senior Director at Alerding CPA Group, an Indianapolis-based public accounting firm. Visit our website:

This post was written by:

Michael Alerding, CPA
Senior Director

Mike has over 40 years of experience in public accounting. He is a prior columnist for The Indianapolis Business Journal and serves on multiple boards throughout Indianapolis. He currently focuses his time on litigation support, business valuations, succession planning consulting and audit and accounting engagements.
See Michael Alerding’s Full Bio ►