The Quest for Perfect Underwriting Knowledge

There is an old Chinese proverb saying, “It is better to light a candle than to curse the darkness.”  I realized this earlier this morning as I attempted to maneuver around out dark house in the wee hours of the morning without turning on lights.  I ended up stubbing my toe on a large box of books we have left out the night before that was to be taken into storage.

I am sure my experience is something that everyone has had at one time or another.  When we look at a request for a business or farm loan, many times, it is like fumbling around in the dark.  Some borrowers assume that we know what is going on in their business and provide us with just enough information to keep us in the dark.  Other borrowers, are so far into the dark themselves they don’t have a clue about the financials of their firm.  Some clients may get quite frustrated when they provide you with what you have asked, only to hear the information provided has generated new questions to get you out of the darkness.  The scariest borrowers may be those to deliberately keep the lender in the dark and feed them just enough to help get the loan closed. 

In any case, it is easy for the analyst to become frustrated, throw up his hands, and call it quits until every single bit of information necessary to understand the company is provided.  It is then we curse at the darkness and refuse to light the candles that we have at our disposal. 

One of these candles is backwards math.  I came across the importance of this in a file for a manufacturing firm. Note that all numbers are changed to protect the identity of the guilty.  At our request, the sponsor had provided us three years of tax returns, interim financials, and a listing of all company debts and payments.  The list showed annual debt service requirements of around $100,000.  The cash flow for the business easily serviced this at over a 2:1 ratio. 

Using a little backwards math tells a different story.  The tax return showed about $80,000 of interest expense.  This seems pretty high for a company with debt service of only $100,000.  When you take the interest expense and use backwards math, imputing an interest rate of 5%, you get $1.6MM of debt.  Take that over 5 years, as most of their debt is on equipment, and you get over $360,000 of annual debt service.  The higher debt balances and payments were further verified by the tax return.

Now my 2:1 debt ratio is at 0.55.  The backwards math candle revealed how ugly these financials truly were. 

Another candle is the resources from the Internet.  I can’t begin to count the number of times one of our fine analysts has uncovered concerning information about the industry or the business itself on a borrower.  We had one deal several years ago that with a simple Internet search and a review from LexisNexis, showed that our sponsor had spent several years in prison for bank fraud! 

Searches need to go beyond just your typical credit report.  Searches for lawsuits, environmental issues, real estate market conditions, industry trends, or news can be a candle to help you understand exactly what lurks in the darkness that you are looking at.  We have uncovered items such as projects that have no chance of cash flowing in the market, collateral next to known leaky underground tanks, business that are becoming obsolete with new technology, and real estate that is located near areas where there may be high crime or questionable enterprises. 

A third candle is the light that a fresh set of eyes can put on your deal.  Let’s face it, when you get into underwriting a credit, often your emotion can cast darkness over an objective review of the company.  Sometimes, the analysts get so far into the weeds that they fail to look above and see the overall conditions of the credit.  It is at those times that a second set of seasoned eyes that are not clouded with the deal can cut through the issues and provide a different prospective. 

A final candle is using ratio and cash flow analysis.  Dicing up the income statement and balance sheet with various ratio analysis tools and comparing the performance and leverage of the company to others in the industry will often show areas of strength and weakness.  Not only is this good for credit analysis, but showing the ratio results to the company may be beneficial in them understanding how to perform better. 

There are more candles than these four that are useful in credit analysis. The next time, instead of sitting in the dark and refusing to do anything until every possible piece of information is provided to you on the company since the beginning of its existence, take what you have a light a few candles.  You may be surprised at the clues you can unlock with what you have!