Red Flags: Save Time and Energy by Identifying Major Problems Immediately

My earliest memory of a “red flag” was in elementary school. When the school bus would drop us off in front of the school, if there was a red flag outside, it meant it was too cold to be on the playground, and we needed to come wait inside for school to start.

I’m not sure how the idea of a red flag came to be, but it now universally seems to mean there is a big problem that deserves attention. In finance, we talk about red flags all the time, as though they are hidden deal breakers and non-starters; and often, they are!

Red flags we often see in spreading financials are when someone has judgments or bankruptcies on their credit report. We immediately know the borrower may have financial management issues. Another red flag is when we see a business borrower collecting unemployment benefits. If a borrower depends on direct government assistance for persona cash flow, it suggests the borrower cannot depend on their business investment or other sources of income. This likely indicates a poor business lending prospect.

Some character red flags we will look for in finance are any evidence of a criminal history. If the borrower has been to jail or convicted of financial malfeasance, this may clearly indicate a bad lending prospect. Your borrower will likely not pay you if they are in jail, so it is better not to risk doing business with someone who may wind up there.

Another red flag we search for is past litigation. If a borrower has a history of being sued, it may indicate potential recurring problems the lender will be exposed to. If a contractor is continually sued for not doing an adequate job, it may be a poor decision to extend credit to that contractor or to lend money to someone who will use that contractor.

Financial red flags, as you may suspect, are a little more obvious. A balance sheet that does not balance is a red flag. Financial statements that cannot be reconciled year-to-year can often be a red flag. Assets and liabilities which we know the borrower owns but are not being reported on financial statements are a red flag.

To expand on that point, a borrower willfully withholding financial information is also a red flag. One year, a borrower refused to provide me with his tax return. I requested his line of credit be shut down until he did provide it. I couldn’t be sure of his financial situation and didn’t feel comfortable extending him credit. He argued I knew his financial position was bad, but I tried to explain to him I didn’t know just how bad it was until I had more information.

When it boils down to it, most red flags are quite obvious. They mostly result when someone is breaking the rules or hiding something. When a loan is requested that has obvious financial problems, we don’t tend to think of that as a red flag, because weeding out bad decisions is a normal part of business. Really, a red flag results when we believe we have an understanding of a request or borrower, and it turns out information had been misrepresented, or a piece of information obtained came as a serious surprise.

While reason for pause when finding red flags may be obvious, how one proceeds with the information is also equally important as identifying the issue. It is important to make sure all decision makers are aware of the red flag, so if the issues are a non-starter for someone, they can incorporate that into their decision. Sometimes people can get comfortable, mitigate, or suggest a way to rehabilitate a red flag. But, this only makes sense if everyone understands the red flag exists and have agreed on how to handle it going forward.

We are also hosting a Basics of Agriculture Lending Class in Miles City, Montana on October 8-9, 2014.  Please contact us for more information.