Industry Ratio Analysis and the Commercial Loan Review Process
This paper examines the use of financial statement industry ratio analysis by businesses from the perspective of commercial lenders. The findings of this paper suggest that commercial lenders consider industry ratio analysis an important component of cash flow projections and of the commercial loan application package. The study also indicates that commercial lenders often consider the use of industry ratio analysis to be critical with regard to the potential success of the business. Twenty-five individual commercial lenders were interviewed and asked questions regarding the importance of industry ratio analysis as part of the commercial loan application for expansion and start-up businesses. These commercial lenders were selected on the basis of their association with eighteen banking institutions with business loan portfolios in excess of $100 million and all were located in various cities in the state of North Dakota.
This paper examines the review of the industry ratio analysis and cash flow projections as a component of the loan application by commercial lenders. This study suggests that commercial lenders consider industry ratio analysis an important component of cash flow projections and of the commercial loan application package. The study also indicates that commercial lenders often consider the use of industry ratio analysis to be critical with regard to the potential success of the business. Other components of a commercial loan application may include evidence of adequate capital, a business plan, a personal credit analysis, and a collateral analysis.
The current paper reports the results of a survey of commercial lenders. Twenty-five individual commercial lenders, located in North Dakota, were interviewed and asked questions regarding the importance of industry ratio analysis and cash flow projections, as part of the commercial loan application, for start-up and growth financing for businesses.
This study addresses issues which may be of concern to commercial lenders who must advise borrowers about the application process. Thus commercial lenders and potential entrepreneurs may find the results of this study useful during the loan application process for start-up businesses.
Individuals wishing to finance a new business with a bank loan must adhere to the application requirements which are established by the commercial lending institution. A theoretical foundation for the premise of this paper is the ‘certification effect’ which was introduced by James (1987). James (1987) found that stock prices of publicly-held companies tend to increase immediately following the announcement of a bank loan to the firm. The contention of James (1987) is that banks have access to more accurate information, about a company’s investment projects, which arises from being a lender to the firm. Investors in the company’s stock may believe they are not in a position to have accurate information about the firm’s investments (Myers and Majluf, 1984). Thus the announcement of a bank loan to that company would be taken as a positive signal about the quality of the business investments of the firm. The current study examines this theory from the perspective of commercial lenders.
The current study builds on the “certification effect” theory (James, 1987). The results of this study suggest that a commercial lender has the potential to efficiently obtain accurate information about a start-up business because of the lending or other banking relationship which may exist.
Data Collection and Methodology
The focus of this study is the use of financial statement industry ratio analysis, by start-up businesses, from the perspective of commercial lenders. Twenty-five individual commercial lenders were selected and interviewed, by phone, with regard to their review of a firm’s industry ratio analysis and cash flow projections as part of the commercial loan application. The twentyfive commercial lenders were selected on the basis of their association with eighteen commercial lending institutions, located in North Dakota. To further qualify to be included in the survey, the majority of the commercial lender’s loans had to be for more than $150,000. The interviews were conducted by phone to ensure adequate coverage of the questions which may be difficult to capture in a written survey.
North Dakota banks were selected as a basis for this study for two reasons. First, for the purpose of comparability it was felt that the bankers questioned should be located in the same state, since funding requirements may vary by state. second, the author is most familiar with the types of funding available in North Dakota and thus was able to coherently discuss the loan procedure with loan officers located in the state.
The survey was limited to only those banks with commercial loan amounts in excess of $150,000. The $150,000 minimum was applied to ensure that the applicable standards applied by the lending institutions are consistent across loan applicants.
The questions were designed to meet three objectives. The first objective is to assess the premise that the process of reviewing the commercial loan application by the lender may serve to validate that an expansion or start-up business is viable. The second objective was to assess the importance of financial statement industry ratio analysis as part of the loan application and as an indicator of the potential success of the expansion or start-up business. The third objective was to evaluate the importance of industry ratio analysis with regard to the loan application and the potential success of the start-up business, from the perspective of the commercial lender.
The first objective was assessed with three questions. Question 1 is a general question which examines the role of the commercial loan review process in validating expansion and start-up businesses. Question 2 addresses the validity of the “certification effect” theory with regard to expansion and start-up businesses, since commercial lenders are asked if they feel their lending association with the business owner is useful in gaining an understanding of what the business is about. The third question assesses the extent of the loan officer’s participation in assisting the potential business owner in developing the loan application which may include and industry ratio analysis and cash flow projections. In question 3, each loan officer was asked the extent to which he/she provides guidance to the loan applicant in developing the loan application including an industry ratio analysis. The extent of the participation on the part of the loan officer would tend to confirm the role that loan officer plays in validating the business expansion.
The second objective was to evaluate the importance of industry ratio analysis as part of the loan application for financing growth and in validating the viability of the growth for existing businesses. The fourth question (i.e. importance of industry ratio analysis with regard to the loan application) and the fifth question (i.e. importance of industry ratio analysis with regard to the potential success of the business) are very much related. If a loan officer believes that a component is important to the potential success of the business then it is quite likely that he/she will believe it is an important part of the loan application. However to meet the objective of this study, both questions were asked of every loan officer surveyed. The reasoning behind asking both questions is to ensure that the commercial loan officer understands that there are two parts to this question and the importance of each part. As will be seen in the results of the study, each of the commercial lenders surveyed answered both of these questions, exactly the same.
Questions 6 and 7 were designed to evaluate the importance of industry ratio analysis with regard to start-up businesses. These questions are similar to questions 4 and 5, above but are related start-up financing versus growth financing. Question 6 seeks to determine if the loan officer spends more time on the competitive strategy than on the other components of the loan application. Question 7 seeks to determine if the loan officer feels as though he/she has some influence over the development of the competitive strategy.
Results of study
The results of the survey suggest, overwhelmingly, that the commercial loan review process, in general, plays a significant role in validating the viability of start-up firms. The survey also found support for the “certification effect” theory with regard to expansion and start-up businesses from the perspective of commercial lenders. The survey also revealed that commercial lenders overwhelmingly consider the financial statement industry ratio analysis to be a significant part of the loan application and an indication of the potential success of the business. Further, commercial loan officers feel that they provide assistance to prospective business owners in developing a well prepared industry ratio analysis and projected cash flows.
Exhibit 2 reports the results of the survey. Panel A reports the findings with regard to the questions which focused on the role of the commercial loan review process, in general, in validating expansion and start-up businesses. All of commercial lenders surveyed indicated that they feel their role in reviewing the loan application is extremely important or important to the potential success of the proposed business. Twenty-three answered extremely important, while only two answered important. All of the commercial lenders interviewed indicated that they felt their lending association with the business owner was extremely useful (23) or useful (2) in gaining an understanding of what the business is about. The third question assesses the extent of the loan officer’s participation in assisting the potential business owner in developing the loan application package. Twenty-two of the loan officers indicated that their guidance in this regard is extensive and three indicated that some guidance was provided. The extent of the participation on the part of the loan officer would tend to confirm the role that loan officer plays in validating the business expansion.
Panel B reports the findings with regard to the questions which focused on the importance of the industry ratio analysis as part of the loan application package and in validating the viability of business expansions. Again, twenty-three answered that the industry ratio analysis is extremely important as part of the loan package and as an indicator of the potential success of the business expansion. Two answered important. The results indicate, overwhelmingly, that industry ratio analysis used in conjunction with cash flow projections are critical in terms of the accept/reject decision.
Panel C reports the findings with regard to the questions which focused on the importance of the industry ratio analysis as part of the loan application package and in validating the viability of start-up businesses. Eleven of the loan officers indicated that the industry ratio analysis is important an important component of the loan application package and an indicator of potential success for the start-up business. Fourteen answered important. The results indicate that industry ratio analysis used in conjunction with cash flow projections may be critical in terms of the accept/reject decision for start-up businesses.
Industry Ratio Analysis
An important contribution of financial statement (FS) industry ratio analysis is that it helps new business owners stay on track with regard to appropriate levels for the various asset categories, such as inventory, accounts receivables, and fixed assets. FS industry ratio analysis also aids in monitoring profits, owners’ salaries, and appropriate debt levels. In this respect, industry ratio analysis is useful for planning, cash flow forecasting, and post-performance evaluation. Industry ratio analysis is also an important part of the commercial loan application.
The Risk Management Association (RMA) currently reports historical and current industry ratio averages for nearly 700 industries. The publication, Annual Statement Studies, is updated annually. RMA was founded in 1914 to help commercial bankers make better lending decisions through the exchange of credit information.
The industries selected for the current study and their descriptions are reported in Exhibit 3. These industries were selected arbitrarily to illustrate their use. RMA also reports the ratios for six size groupings, based on total assets and total sales. The ratios reported, in this section, for each industry represent those for the mid-size sales category, reported by RMA, for each industry.
Exhibits 4 and 5 report the ratios and corresponding dollar amounts for the balance sheets and income statements, for each of the four industries. The corresponding dollar amounts were computed using the industry ratios reported by RMA and a $750,000 total asset base for each of the four industries. The corresponding dollar amounts were incorporated into the illustration to increase understanding and comparability of the ratios. The dollar amounts were computed by multiplying the ratio for each balance sheet category by total assets ($750,000) for each of the four industries. Exhibit 6 reports other selected ratios for each of the four industries.
It can be observed from Exhibit 4 that the commercial bakery (CB) and the paint, glass, and wallpaper store (PGW) both have a high level of trade receivables, versus low receivables for the veterinary business (VB) and the restaurant (RST). This may reflect that the CB and the PGW have commercial customers, who are billed after receiving the product. Inventory level is highest for the PGW, which is as expected since a high level is needed in this business to meet immediate customer demand. Fixed assets is highest for the RST as expected since a wellconstructed eating area and kitchen area (refrigeration and cooking equipment) would be necessary for this business.
The most common type of intangible asset for small businesses are investments in franchise. Since the balance for intangibles may depend on whether or not the business is a franchise, the ratio may not be completely reflective of any particular types of industries. Of these four industries, the VB has the highest amount versus the lowest amount for the PGW. The high amount for the VB may reflect the value placed on technical expertise possessed by veterinarians. The low amount for PGW may reflect the lower cost of obtaining a franchise in this business or the absence of franchises. Other current and non-current assets may reflect prepaid advertising expenses, pre-paid leases, utility deposits, and other pre-paid items.
Short-term notes payable, current maturities of long-term debt and long-term debt represent the interest-bearing liabilities (i.e. debt) of the business. There does not appear to be any extreme difference in average debt levels for these industries. However, the RST has the highest level of interest bearing debt. This may reflect the higher quality of the restaurant assets as collateral.
Generally the easier it is to re-use the assets the higher the lending ratio will be. Trade payables are highest for the CB. This probably reflects that vendors of CBs bill the CBs after the bakery supplies are received. Income tax payable represents the current portion of income taxes due and will depend on the quarterly payment amounts and the timing of them. Income taxes payable is negligible for all four industries. Non-current liabilities may represent long-term customer prepaid contracts. Nothing out of the ordinary can be observed for this balance sheet item.
The net worth represents the existing investment in the business. Equity investment is highest for the PGW store, followed by the VB, the CB and the RST, respectively. Required equity investments are a reflection of the riskiness of the business and commercial lenders will require different amounts based on the type of business. Thus those businesses with high required equities will have correspondingly lower interest-bearing debt levels.
From Exhibit 5, the VB has the highest after-tax profit and the highest owners’ salaries. This probably reflects the higher income required by veterinarian professionals. The other three industries have lower after-tax profits and lower owners’ salaries. Also cost of sales and other operating expenses are noticeable lower for the VB which also reflects the nature of professional service industries. Income statement amounts were computed by multiplying the corresponding ratio by the net sales amount. Net sales were computed by multiplying the ratio of net sales/net fixed assets (from RMA) by net fixed assets for each industry.
From Exhibit 6, the PGW has the highest investment in operating working capital which reflects the higher level of inventory required by this industry. The RST has the lowest level of operating working capital which reflects the higher level of current operating liabilities. Operating working capital is computed as current operating assets (i.e. cash, receivables, inventory and other current assets) minus current operating liabilities (i.e. trade payables, income tax payable, and other current liabilities). The RST has negative operating working capital which reflects the low level of current assets and high level of current liabilities required by this industry.
The VB has the highest sales/total operating assets, sales/net fixed assets, and sales/operating working capital ratios. This indicates that a lower investment is required to generate sales (fees) for the VB. The RST has the highest level of debt with a debt to operating asset ratio of 0.98. Debt is calculated by adding short-term notes payable, current maturities of long-term debt, and long-term debt from the balance sheet. Debt represents the interest-bearing liabilities of the business. Total operating assets is computed by subtracting all the operating liabilities (i.e. trade payables, income tax payable, other current and non-current liabilities) from the total assets of the business. The operating liabilities are subtracted since they generally represent free funding for the business and reduce the equity investment in the business and the required debt financing. Return on total operating assets (ROA) is useful to the managers of the company as well as to commercial lenders in analyzing the ability of the firm to earn a profit and repay the debt. ROA provides a true measure of the return earned on the capital employed in the business. It is computed as the after-tax operating profit before interest expense divided by the total operating assets. Total operating assets is the total assets of the business less all of the operating (noninterest bearing) liabilities. Operating liabilities include trade payables, income tax payable, and other current and non-current operating liabilities. The performance of the business owners and the strategic position of the company can also be observed by an examination of the business’s operating performance. ROA is highest for the VB which reflects the higher income required by veterinarian professionals. The probability of default is relatively low for all four industries, indicating a high probability that the business will be able to pay the interest-bearing debt obligation ongoing.
The findings of this paper suggest that the commercial loan review process plays an important role in validating the viability of start-up businesses. This study found support for the “certification effect” from the perspective of commercial lenders. Clearly the loan process provides an assessment of both the firm trying to identify sources of financing as well as the lending institution. This verifies previous findings in the literature (James, 1987).
The contribution of the present study is to reveal that in all of the major financial institutions in North Dakota, the message to the prospective entrepreneur is that industry analysis may be critical to any expansion even start-up businesses. One could reasonably assume that these results would be similar in states across the country.
The message to both lending institutions and prospective businesses is clear. In order to have a business loan approved, there must be considerable effort on the part of the business in assembling a thorough industry and cash flow analysis and a high level of effort on the part of the lending institution in reviewing this plan. The combination of these efforts will result in a “certification effect” that is meaningful for both the business and the lending institution. The results of this study were very consistent across the lenders surveyed. Further study should investigate whether or not these results hold true in other areas of the country.
James, C. (1987). Some Evidence on the Uniqueness of Bank Loans, Journal of Financial Economics 19.217-236.
Myers, S. and Majluf, N. (1984). Corporate Investment and Financing Decisions When Firms Have Information that Investors Do Not Have, Journal of Financial Economics 13, pp. 187- 222.
Nancy Beneda, Ph.D., C.P.A.
Nancy Beneda is an Associate Professor and Vaaler Insurance Fellow for the Department of Finance at the University of North Dakota. She may be reached via email at nancv.beneda(a)Mnd.nodak.edu
Copyright Credit Research Foundation Fourth Quarter 2006
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