I have always maintained that commercial underwriting is like being a private investigator. You are sifting through clues in order to determine the financial health of the company regarding the loan request, or to gauge how the company is performing now that the loan has closed.
Financial statements help to reveal the clues. But, an inaccurate understanding of the basis of the reporting on the financials, can lead to conclusions based upon errors. One of the best ways to provide yourself with adequate clues is to obtain the following statements from your commercial or farm customer on a regular basis: balance sheet, income statement, statement of cash flows, statement of changes in owner equity, and cash budget. Are these necessary in all lending cases? No. Larger and more complex credit customers should provide this information, as it also can be a planning and benchmark tool for the company.
The financials also lead the prudent analyst to ask several questions. The first would be, is the accounting system cash or accrual based? Or is it a mix of the two? Typical cash based systems do not recognize income unless it has been received. The company carries no receivables on its balance sheet. This can cause some challenges in determining the financial result for a certain time period. A company could have made a large sale on account at the end of the year, and may not receive payment until next year. Under a cash based system, the sale would not be posted until the following year, and expenses associated with the sale would be posted when they are incurred. This would tend to understate the performance in the first year and overstate it in the next.
Another question is, how are items, purchased for the production of a good, treated? An example here would be the hog farmer. When the farmer purchases a pig, is that treated as livestock inventory on the asset side of the balance sheet or as a cash expense? When the pig is fed, is the feed expensed on the income statement, or is it added into the pig inventory side of the balance sheet? And, if the feed is added to the balance sheet side, one may miss the cash implications of that, if they do not have an accurate statement of cash flows.
The valuation of assets is another example with wide variations. According to Generally Accepted Accounting Principals (GAAP) and the Farm Financial Standards Council (FFSC), the following methods are acceptable to value assets:
1. Historical cost. This lists the cost paid for the asset and possibly the cost of production that was added to the raw material to get the ending inventory. GAAP wants things valued on the balance sheet at the lower of cost or market. An example here is a hog that cost $750 would be reported on the balance sheet at $750. Now, if it cost another $100 in feed and vet bills, the cost could be reported at $850.
2. Current market values. This is done a lot in ag and is useful to lenders to ascertain the true liquid value of the farm inventory (crops or animals), in order to get a truer picture of the cash value of the assets, if they were sold today. There are different value methods for the market. A farmer could just pull the ending price on heifers and use that to determine his breeding stock’s value. A company could look at an orderly liquidation value to determine the value of its inventory that it would need to sell in an orderly, discounted sale. The market value for the same heifer here is now at $1,000. So that is how the bovine is valued.
3. Net realizable value method. This takes the net expected value after any closing, sales, and transportation costs are taken from the proceeds. To sell the heifer will cost $50 in sale and transportation costs. This results in a value of $950.
4. Discounted cash flows method. This is done some in commercial real estate. The value becomes the sum of the Present Value of all future stream of net cash inflows over the life of the asset. Usually a residual value at the time of disposition is also used. This amount is usually discounted with a discount rate that represents the cost of funds for the client. The example here is the same heifer that cost $750 costs $100 per year to feed and keep healthy. The animal is expected to produce calves in years 2 and 3 and then be sold for $1,000 at the end of year 3. The cost of funds for the farmer is 6%. This results in a value of $687.13 on the same heifer.
So, any of these methods could be used to determine values; and in some cases, multiple methods are used within one set of financials. Yet, the amounts range from $687.13-$1,000. When multiplied over a large number of cattle, the amount can vary widely. You may also see the “whatever value I can pull from my head” method on a balance sheet. Who knows what sort of value will show up under your cattle when that method is used. Differences in the valuation methods can result in different variations in the actual values. Unlocking the clues that are hidden within the financial statements are required in order to determine the financial health of the business.