The Do's and Don'ts of Financial Spreading

A major part of credit analysis is reviewing financial information. Many businesses will provide information from their own personal bookkeeping, while others may enlist accountants to produce highly refined statements and audits. No matter the quality of these statements, decision makers want to be able to quickly identify the risk and act decisively.

Financial spreading is the most common way an organization relays the risk to a decision maker efficiently. Spreading is an organization’s process of standardizing the presentation of financials, while also identifying major risks apparent in those statements. The “spreads” can be done on vendor software or on an internally designed system, such as a spreadsheet. Major spreading goals often include segregating current assets and liabilities from their non-current counterparts, segregating tangible assets from intangible assets, and identifying significant accounts that aren’t readily understood. On the P&L side, spreading aims to segregate gross profit activity from operating profit activity, cash events from non-cash events, and also identifying significant income sources and expenses that are not readily understood.

The aim of spreading financials should not be to alter the statement in any material matter, but restate the financials in a more useful format. Thus, all financial spreads should “foot” to their original documents. Total assets, liabilities, and net worth should be the same on the spreads as they are on the provided statements. If any significant adjustment is required, it should be well-documented.

The income statement should also foot to the original statements. And, the income statement should be reconciled to the balance sheet. If a business yielded a $1 million net profit, then the net worth of the business should have increased by $1 million. If net worth does not reconcile, an explanation should be sought. It is not uncommon for a business to make distributions or receive contributions, which directly impact net worth and are reasonable adjustments to make to net worth. If net worth cannot be reconciled to the income statement with a reasonable explanation, then there is unexplained balance sheet activity, and a red flag should be raised.

Like all analysis tools, spreads are not a one-size-fits-all tool. Financial spreads are commonly used to evaluate commercial and industrial activity, more commonly referred to as C&I. In these spreads, the aim is to understand leverage, liquidity and profit margins. These spreads will be unhelpful in evaluating commercial real estate (CRE) loans, in which we are more concerned with loan-to-value, net operating income and changes in market rents. While less common, there is special software that spreads real estate financial information. Even agriculture will likely have special spreading considerations, because it is important the decision maker understands the quantity and price of the current marketable assets on the balance sheet for the spreads to be of any use. This would suggest C&I and CRE spreads wouldn’t be adequate in analyzing agriculture.

To summarize, spreading is done to standardize how an organization tracks and reads financial statements. Spreading may involve re-categorizing accounts, so a business can be more easily evaluated, but spreads should still foot to their original source documentation. Reconciling income statements to the balance sheet are especially important, because it is an indicator of whether all financial activities are accounted for. And lastly, it is important to know not all spreading software will be useful for all financial statements reviewed. Most software is built for C&I information; whereas, CRE and agriculture will have their own special spreading requirements.