The Agony and Ecstasy of ProFormas
|This article forms part of a series written by Andre Schroer which is 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.|
This article builds on the previous one, “Analysis Paralysis or not? The significance and/or relevance of ratios”
The Agony and Ecstasy of ProFormas or Why Is My Commercial Lender Tormenting Me?
Part 1 – The unmasking of risk
Previous articles have explored the rationale of loan covenants and the significance of financial ratios. More often than not these are concepts that to the borrower appear imposed by the lender. They may or may not be understood. At times they may even seem Idiosyncratic. Often they are grudgingly accepted as a means to an end or an obligatory exercise in satisfying the lender. But few lending stipulations can surpass a borrower’s potential distress level than the request for proformas. Typically they are at least two years out but can be requested for a three to five year period. They may involve monthly, quarterly, or annual periods and typically they require both P & L, Balance Sheet and cash flow projections, with a specific focus on security margin. To the prospective borrower this request can appear overwhelming; the ultimate coup de grâce in the tortuous loan application process.
This and the three ensuing articles will explore the needs, benefits, and missteps around the application of proformas. Part 1 – the unmasking of risk, focuses on the strategic underpinnings of the exercise. Part 2 – the relationship between the balance sheet and the income statement, and Part 3 investigates the connection between Proformas and loan margins. Part 4 explores the notion that neither the entrepreneur nor their accountant might be the best person to prepare financial projections
If the Loan Commitment calls for projected P & L, balance sheet, and cash-flow projections, and if the borrower has not already gone through this exercise, there is a good chance that he or she will ask the accountant to complete the request for the lender. The accountant will review the company’s financial history, may or may not ask a few questions of the borrower and will pound out for the lender (as generic as possible) the required projections. The borrower happily hands these over to the lender, who files them away with the other closing loan documents. The borrower in all likelihood files the projections away with the loan agreement. Wrong. . . wrong . . . wrong. A year later at the time of the annual review, (or sooner in the case of an offside position) the lender will pull out the filled projections and in nine out of ten cases, both lender and borrower are now faced with a problematic task of explaining the variance between projections and actuals.
Figuring out the Risk Drivers (double-entendre intended)
Running a small to medium enterprise is typically a complex and rather an all-consuming challenge. There are so many daily decisions to be made that even the most proactive and strategic manager can be readily distracted by the exigency of shifting financial conditions. Governments undergo elections, lending institutions change account managers, key personnel leaves, suppliers experience delivery problems and creditors experience financial problems. It is sometimes difficult to see the forest for the trees and what frequently happens is that the owner manager – instead of managing the financing process – becomes ensnared by it.
If the borrower would consider the application of mapping out projections as a personal strategic exercise to identify, prioritize and quantify financial risk rather than a document prepared at the behest of their lender, then the effort involved becomes much more helpful and consequential. Paradoxically it could be argued that projections that miss the boat but that are built on careful analysis and thoughtful assumptions are more useful than fairly broad or generic ones that are bang on target. Sounds irrational? Here’s a simple demonstration: Company A has recently expanded from rented space to an owner occupied plant, which the lender has agreed to finance. The accountant, using the past three years’ financials determines that the gross margin for company A is 60%. However, the company has over the past year initiated a successful predatory pricing policy; supported by more generous credit terms. The mortgage agreement required Company A to provide detailed financial proformas and cash flow projections and (on a go-forward basis) quarterly financial reports to support quarterly interim reviews. Because the “thinking” around the financing request was essentially undertaken to satisfy the lender and left up to the accountant to complete, a key underlying and driving assumption was not identified. It would likely have led to an under-financing request and worse still could easily undermine the lender’s confidence in the borrower at the time of the first review. The point is not that the newly generated gross margin was incorrect. Rather the point is that there was no thinking around the fact that the company’s altered business practice had altered same. At the risk of tautological redundancy had the borrower thought about the impact of the lower prices and extended credit terms even if the assumed margin ratio turned out to be incorrect, the fact that these determinants were considered was better than the alternative broader and generic application. The strategic thinking that was applied means that the causes for variances can be much more easily and readily recognized. Of course, and equally as important so can be, a fitting corrective action.
In other words, the borrower who undertakes the exercise of preparing proformas for their own and not the lender’s sake will benefit from a more strategic and tactical (5-thousand feet up) perspective and while this may not be readily apparent, the exercise essentially boils down to the borrower’s identification, acceptance, and management of risk. The first involves the borrower’s objective assessment of risk; the second involves his or her risk appetite. These two themes are interwoven by the company’s growth strategy. In this day and age, business gurus are obsessed with the notion of growth. Grow or die is a recurring mantra. A status quo or a growth strategy involves different risks. It is not a given that a growth strategy is always the only or optimum solution. Growth requires a certain degree of leverage; which entails risk. No growth involves lower internal financial risk but incurs external competitive risk. Stronger growth commonly requires of the shareholder a greater financial commitment. The risk is higher; however, the returns can also be larger. No growth (at least from a balance sheet perspective) may require less shareholder commitment but can also yield lower returns on the shareholder(s)’ equity.
The balancing act is not always straightforward; however, it is important that the decision points are established at the outset and are reviewed from time to time in a detached and thoughtful manner. The lure of the opportunity may easily cloud judgment and impede the objective assessment of risk. More often than not, the opportunity to expand and/or acquire premises, to develop a new product line; to land a new sales contract, or to expand territory is driven by the appeal of an increase to the top line. Not always is due consideration given to the additional risk component.
Let us step back and reconsider the need for external financing. Essentially companies obtain financing to hold inventory and receivables; which, in turn, are converted into sales and cash. Additionally, businesses borrow to finance the acquisition of plants and equipment. If an enterprise is experiencing nominal growth, it stands to reason that, over time, its borrowing requirements should decrease.
If there is a reasonable amount of profit retention, the external borrowings should gradually be replaced by increasing equity. The same holds true for the term loans utilized to finance capital expenditures. In a stable environment a business would be replacing capital assets; rather than, adding to them. (The one exception may be an external competitive technological driver, which could force new capital expenditures.) In all other instances, a company experiencing little growth should have nominal long-term financing requirements.
In growth mode, the company usually combines its own equity with external financing sources to ramp up the asset conversion cycle; (i.e. capital assets ® inventory ® receivables ® cash.) Some of the borrowing requests in this type of a situation could include:
- A request to assist in the financing of plant and equipment to increase the modes of production.
- A request to assist in the financing of additional inventory to increase the company’s product line and sales capacity
- A request to increase the operating line to allow for higher levels of receivable financing in line with greater sales volumes
- A request to provide increased working capital to allow for ramp up expenses (e.g. the development of a new territory, training of additional people, etc.)
Each of the above scenarios brings with it a set of new risks:
Risks involving capital expansion:
- The equipment may experience general teething and start-up problems, resulting in lost productivity and lower profitability.
- The equipment may have poor performance capabilities, again resulting in downtime and lost profits.
- Increased capital expenditures could result in balance sheet distortions with too much equity tied up in capital assets.
- The increased sales may not materialize from the increased production. There may be sales increases; however, they may not be enough to offset the higher financing costs of the equipment.
- The company may be incurring an opportunity cost. For example, it might have outsourced additional production at a lower investment but similar yields.
Risks involving increased inventory:
- Higher inventory levels could impair working capital turnover efficiencies and could lead to higher financing costs.
- Higher inventory levels could create working cash flow shortfalls since too much of the working capital might be consumed by an asset that cannot be quickly converted into cash.
- Higher inventory levels will likely eat into the borrower’s operating line. Typically a lender will allow for a lower margin on inventory as opposed to receivables. For example, let us assume the borrower enjoys a $600 thousand facility which is to be margined by 75% of under-90 day accounts receivable and 25% of inventory. If the borrower is utilizing $400 thousand of the line against $400 thousand in receivables and $400 thousand in inventory the operating line is operating within the stipulated margin conditions. (A/R margined lending value = $300 thousand; inventory margined lending value = $100 thousand.) However should the borrower increase the inventory by 50% in anticipation of increased sales, then the operating line could be in default by some $150 thousand. (Increased line to $600 to purchase additional inventory is still within established borrowing ceiling. However, the lending margin coverage is only $450 thousand. A/R margined lending value = $300 thousand; inventory margined lending value = $150 thousand.) Based on this simplistic sketch it is clear that the borrower has no additional equity to co-finance the increased volumes. The lender is asked to provide 100% of the additional financing and unless the borrower can very quickly and efficiently turn the inventory into sales, the lender and borrower might well be having a serious heart to heart conversation.
- If the inventory turns are poor, the company stands the risk of stockpiling towards potential obsolescence. The excess inventory may have to be sold at a loss or may have to be carried over a protracted period; thereby tying up non-productive working capital and incurring higher interest and other carrying costs.
Risks involving increased receivable levels:
- Higher term sales may require higher operating lines. If the company’s equity base is deemed weak, by its lenders than the higher working capital lines may not be readily forthcoming.
- If the borrower is buying (i.e. selling on concessionary terms to increase volumes) there is a risk of eroding profitability.
- New customers incur higher credit risk, as the company has no track record with the new buyers. In fact, the new account may have been landed more because of the company’s credit policies and less because of the product offering. In such cases, the borrower could be inheriting someone else’s problem.
Each of the above situations involves three related components:
- Risk adjudication, i.e. defining the inherent risk arising out of an intended growth strategy.
- Risk weighting; i.e. determining the degree of risk that is sustainable with a business’ established financial wherewithal.
- Risk timing; i.e. calculating how likely or quickly the risk exposure (as in the example of the increased inventory investment) can be regularized.
The risk adjudication process remains fairly self-evident. For the most part, it is a process requiring both imagination and common sense. Why imagination? The more conceivable road blocks or contingencies the borrower can envisage, the better his or her state of preparedness if difficulties do eventually arrive. Certainly, if the borrower does not stop to foresee some forks in the road, his or her lender surely will. Common sense is also required to bring clarity and sound judgment to the expansion decision.
So . . . how does the preparation of cash-flow projections, profit and loss statements and balance sheet proformas relate to some of the afore-mentioned reis determinants?
These risks can, in most cases, be quantified. A thoughtful and strategic borrower will ensure that to the best of their abilities they are underpinning their calculations with well-defined assumptions. A sophisticated borrower will determine, based on their assumptions a best case, a worst case and a likely-achievable scenario. These sensitivity analyses will quantify the degree of risk involved and will allow the borrower to make choices based on rational determinants. Well thought out projections, based on logical and considered assumptions reduce unquantifiable risk. They will enable the borrower to map a more strategic course of action and will facilitate early-stage corrective action. Just as importantly, they will create a more useful and constructive means of communication between borrower and lender; one that is built on a deeper and more comprehensive understanding of the company’s financial requirements and one that allows for flexibility in responding to future needs.
The next article will expand on these concepts. . .
The Agony and Ecstasy of Pro Formas Part 2
– the relationship between the balance sheet and the income statement.