Securing a Small Business Loan – “Winging It”Posted on March 25th, 2017
Outsourced Accounting Department, Inc.
Now, having written several articles in this series on how to approach a lender, here’s what happens when you ignore these steps and rely on the lender to figure it out.
We have a client who operates two businesses that originally provided the same service, but were set up as two separate businesses for marketing purposes. Our client then (arbitrarily) writes checks and incurs credit card charges in each company often for the other company’s expenses, thus co-mingling expenses between the two companies. Consequently, one company could be showing a large profit, while the other is showing a loss. Then along the way, a new product line was introduced under one of the businesses requiring a substantial investment in inventory.
Each company’s tax return is prepared separately based on whatever the profit or loss is shown for that company (as it was impossible at that point to know to which company the various expenses actually belonged as they do the same thing). In the case of the company with the inventory, for tax purposes, they were allowed to deduct the entire amount of inventory purchases in the first year it was purchased. This resulted in a large “book to tax adjustment” by the CPA who prepared the company’s tax return.
Because each of these companies is owned 100% by the same owners, our firm also prepares Combined Financial Statements for them every year based on their book financial statements which match inventory costs to their related revenues, and we then eliminate the inter-company transactions. This is permissible under Generally Accepted Accounting Principles (“GAAP”), and provides a true picture of the two companies’ combined profit or loss as if it were one company.
Now, enter a prospective lender. Our client wishes to obtain a loan through one of the companies, so the lender requests tax returns for only that company, which in this case, was the one showing a tax loss. Then the lender requested some additional information, and we provided them with the combined financial statements. These showed that on a combined basis, the two businesses (shown side by side along with all eliminating entries) were quite profitable. However, the lender only zeros in on the book loss of its prospective borrower which, for book purposes as described above, is much larger than what is reflected on its tax return.
First, suffice it to say this is NOT the way to establish a banking relationship, position your company, and apply for a loan, as discussed in Parts I, II, and III of this series. As a result, our client created mass confusion with the lender, resulting in his or her lack of trust and confidence in the numbers. And our client’s reaction at this point?
But too late, the damage is done! As I have discussed in numerous articles, bank lenders today are conditioned to rely only on tax returns to analyze the borrower’s profitability. This is utter nonsense, as tax returns are not designed for that purpose. However, today’s lending officers don’t understand this, and often don’t care. If the deal doesn’t fit their “cookie-cutter” guidelines it takes more time to analyze. And in today’s banking industry, large banks in particular don’t want to spend time underwriting “small” business loans, so they often just decline it and move on.
So what is the solution to all of this? In today’s banking environment more than ever before, you have to be smarter than the lender, meaning anticipate whatever is going to cause him or her heartburn, and then deal with it right up front:
- Do NOT spring tax returns on them showing losses and expect to get your loan approved. Lenders need to see a history of profitability which is necessary to repay their loan. (See Part III of this series regarding “Understanding the Lender’s Underwriting Criteria.”)
- Instead, and assuming your business is profitable on a book basis, along with the tax returns, provide “compiled” or “reviewed financial” statements based on your book financials, and prepared by a CPA in accordance with GAAP on their letterhead. (See Part II of this series.)
- If your CPA cannot or will not provide GAAP statements and focuses only on tax preparation, then find a CPA firm that does both tax and GAAP financial statements.
- Explain the differences between your book and tax financials right up front – BEFORE he or she even begins their loan approval process. (See Part I of this series regarding “Build Rapport,” as well as Part II above).
As always, if you need assistance in dealing with prospective lenders, don’t hesitate to consult with your CPA or other financial professional, someone who can effectively communicate the above accounting issues to your lender,.