Analysis Paralysis or Not? The Significance And/Or Relevance of Lending Ratios.
|This article forms part of a series written by Andre Schroer intended to de-mystify the commercial lending process. Too often than not, disconnects between Lender and Borrower are triggered by poor communication. To the untested Borrower, the process may seem fearsome, involving mystifying rules of engagement. Buzzwords and industry precepts often appear taxing. Perceptions of risk may not be understood and/or aligned. Hopefully, these articles will assist in closing the financing gap between Borrowers and Lenders.|
The article builds on the previous one, “Thou shalt and thou shalt not. What’s with all those conditions, margins and covenants?”
Analysis Paralysis or not? The significance and/or relevance of lending ratios.
With apologies to their original authors, the following quotations might appropriately reflect the challenge of excessive reliance on ratios
“. . .you might prove anything by ratios and
. . . he uses ratios as a drunken man uses lamp-posts –
– for support rather than illumination”
The problem with ratios is that lenders and the occasional borrower can get obsessed with them, to the detriment of other concerns. Ratios serve as useful comparative measurements. They can also uncover ongoing financial trends. But in the final analysis lenders and entrepreneurs need to get underneath the numbers and must remain mindful of how meaningful and/or useful any information they provide might be. By way of example, an SME owner may feel justifiably proud that his or her sales revenues have shown a 15% year over year increase. But that ratio could point in several directions. Sales volumes may have increased because of aggressive pricing with an ensuing deterioration in gross margin. Or the company may have just passed along its cost of sales so that its gross margin remained exactly as in the previous year. Conversely, the company may have effectively increased product pricing while maintaining previously established costs of sales, thereby improving its gross margin. The 15% growth ratio, without a thoroughgoing contextual examination, could remain immaterial. In other words, for ratios to have a meaningful significance to both borrowers and lenders, they need to be analyzed in context and examined within a global framework.
Measurement ratios most commonly used by lenders can be categorized into the following five sets:
1. Performance Ratios
These measure certain characteristics of the income statement both in relation to the top line and its relationship to the balance sheet. They would include:
- Growth ratios (e.g. Sales grew by x% year over year)
- Margin ratios (e.g. gross margins, operating margins, net margins, etc.)
- Return ratios (e.g. return on assets, return on equity, return on investment, etc.
2. Coverage Ratios
The previous article dealt with some of these types of ratios. They are generally applied to issues surrounding risk protection, as in repayment capacity, receivable and/or inventory coverage tests. The most common ones include:
- Interest coverage ratio
- Debt service coverage ratio
- Margin coverage ratio on assets securing financing
3. Turnover Ratios
These are efficiency ratios that measure how effectively the company is managing its financial resources. The major ones include:
- Working capital turnover ratio
- Inventory/Receivable turnover ratios
- Payable turnover ratios
4. Balance Sheet Ratios
These ratios deal with structural issues. For example working capital and equity levels are common measurements; as are leverage issues. The most common ratios include:
- Current ratio
- Quick ratio
- Long term debt/Total debt to equity
5. Peer Measurements
All of the above ratios usually enjoy a certain common attribute amongst other players in the same industry group. For example, trucking companies will record high long-term debt to equity ratios because of their significant investment in rolling stock. Similarly, food retailers will have very low receivable turnover whereas engineering firms or contractors may have fairly extended receivables. The purpose of these comparisons is to benchmark the borrower’s performance characteristics against those of the peer group.
As previously indicated, the challenge with ratios is not to get obsessed with the ratio; but rather to look underneath the numbers and uncover the story that these numbers reveal. To applaud the aforementioned fifteen percent growth rate could signify very little unto and by itself unless it’s bucking an industry-wide trend or unless the rest of the borrower’s financial performance matches the top line growth. Even where top line growth is recorded at fifteen percent but the bottom line results are the same as in the previous year this combination of facts is more significant than the growth itself. It could mean that the borrower is buying the business; that he or she has undertaken a deliberate and aggressive growth initiative while being unable to adequately adjust variable costs; or that he or she has let fixed expenditures escalate disproportionately. Alternatively, a borrower may be involved in commodities and may record a substantial percentage swing either way on the top line while maintaining the same profit levels. In this case, the volumes probably stayed constant and the borrower was able to pass through the costs at adjusted price levels.
Probably the most useful and commonly applied ratio involves year over year comparisons. Both borrowers and lenders usually buy into the inherent benefit of surveying directional trends. However, here also, the reason underlying a specific ratio should always be more significant than the number on its own. Ratios can also provide a useful “pointer” function; that is, the ability to uncover clues to a particular financial performance characteristic or the ability to signal potential problem areas.
How does the foregoing affect a borrower’s request for financing? And how can the dreaded ratio influence the borrowing/lending relationship?
- The better borrowers’ understand the language of ratios and lenders’ reliance on same the better they will be equipped to get on the same page during any review of their financing with their lenders
- For SME owners the growth and makeup of their business often involve lifestyle choices. Accordingly, their company may remain quite successful yet record highly unsatisfactory peer comparisons. A savvy borrower recognizes potential “ratio turbulence” and remains proactive in walking their lender through a “ratio re-think”. The writer is reminded of a smallish second-generation, family-owned manufacturing company located in rural Ontario. The company had outgrown its local branch manager; had outgrown its regional branch manager and had eventually graduated to the banks head office on Bay Street, where in short order the loan was classified as unsatisfactory. Why? The company’s property was situated on 500 acres of prime shoreline on one of Muskoka’s prestigious lakes.
The inclusion of this property on its balance sheet completely and unfavorably skewed the company’s return on asset ratio. From a peer group benchmarking perspective, the company appeared to the new account manager as a colossal underperformer. Yet the company systematically generated sustained year over year profitability.
The family’s decision not to develop the property’s shoreline potential was a lifestyle choice; but one that, in terms of their company’s particular performance ratio, set it wildly apart from its peer group. The fact that the lender didn’t understand the unique balance sheet characteristic; nor the fact that the borrower didn’t comprehend the lender’s concern ultimately led to a breakup of their 50-year relationship.
Like many of us, lenders can get captivated by ratios. A savvy borrower will understand where to push back when an undue emphasis is paid to one particular ratio. More importantly, he or she will be able to present a compelling argument as to why the “offending” ratio does not inherently represent an undue risk to the Lender.
An examination of the differing ratios between an SME operator and industry norms can sometimes prove immaterial in significance, could highlight performance weaknesses, or actually provide hidden clues to future problems or conversely to new strategic initiatives. In general terms, they provide useful guideposts to lenders.
That being said if a borrower’s financial performance falls outside their industry’s accepted standards for legitimate reasons, the borrower should be able to (a) explain these reasons to the lender, (b) should not adhere to shoe boxed margining structures and (c) should be prepared to offer the lenders useful workarounds to provide same with their requisite risk mitigants. The takeaway for a borrower might be summarized as follows.
Know and understand your company’s financial ratios as you would your child’s medical charts. Don’t wait for the lender to stumble across some offending ratio. Be pre-emptive in identifying the misfits and be proactive in offering resolutions where there is a potential roadblock. It will accentuate your financial acumen while improving the chances of a successful loan sanction.
And just as important: Borrowers should understand any ratio tests they are agreeing to in their loan commitments. If the required performance ratio won’t work for their company, they are merely postponing an inevitable showdown with their lender.
Here is a random sampling of four of the more common disconnects between lenders and borrowers when the feared ratio is used as a credit adjudication tool:
Lenders are guided by industry norms. Variances are typically frowned upon.
|1. Turnover ratios for accounts receivable and accounts payable.
2. Inventory Turnover.
3. Debt to Worth.
4. Net Margin.
¨ Ratios may be influenced by a highly credit worthy client base. Alternatively, the borrower ‘s receivables might be secured
¨ Borrower might be very skilled at leveraging trade debt, thereby adversely skewing their accounts payable turnover ratio
Possible risk mitigants
¨ Borrower might be prepared to offer off-balance sheet security to address and reduce the lender’s concerns
¨ Higher inventory levels or slower turnover usually spell reduced profitability.
§ Could be influenced by a myriad of possible reasons; such as a seasonality issue, a franchise requirement, a bulk purchase, the introduction of a new line, or others.
Possible risk mitigants:
¨ An operating bulge facility may often address seasonality issues
¨ If the balance sheet remains strong and working capital loans can be structured without margined inventory security, it might be best for the borrower-lender relationship to reduce reliance on inventory and substitute either other balance sheet items for security purposes or offer off-balance sheet security
¨ A somewhat significant ratio, this one indicates the cushion between the creditors and the shareholders
¨ Could be an unincorporated company where the principal remains unconcerned about personal liability. Other indirect determinants such as tax, succession and/or estate planning could have a bearing on the company’s financial structure
Possible risk mitigants:
¨ This is a ratio that the lender will generally vigorously pursue and it is a battle that the borrower will lose almost every time.
¨ The borrower should be prepared to bridge the gap by off-balance sheet security or if this is not an option be prepared to research ancillary financing accommodation via asset-based lenders.
¨ This can be categorized as a clue ratio. When benchmarked it could indicate a better or poorer performer. It could also hide top-heavy owner’s draws/dividends
¨ Year over year deterioration can also signal downstream financial distress.
¨ The company could be an end-of-life cycle cash cow, not needing to invest in growth
¨ The owner might be guided by lifestyle choices, not wishing to grow the company
Possible risk mitigants
¨ Borrower would likely face resistance if significant working capital financing is being sought. Some well-defined term financing could still be available
¨ For operating loans the borrower should be prepared to provide off-balance sheet security and/or demonstrate ability to re-establish acceptable profit margins
In summation, ratios can serve as a constructive indicator of trends and potential problem areas. Yet, if misread, they can also handcuff a borrower in the lending relationship. A savvy borrower will recognize potential disparities and will be proactive in recommending workarounds to their lender.
The next article . . .
The Agony and Ecstasy of Pro Formas
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