Thanks to Timothy W Koch, Bank Management, 6th edition & John W. Day, MBA

1. Reading & Analyzing Non-RE Business Ratios & Financial Statements for Commercial Funding Pre-Qualifications & Underwriting Thanks to Timothy W Koch, Bank Management, 6th edition & John W. Day, MBA

2. EITHER of these errors reduces the number of successful loans for lenders • Type I Error • Making a loan to a customer who will ultimately default • Type II Error • Denying a loan to a customer who would have ultimately repaid the debt in full Obviously, lenders want to minimize origination of loans that will go bad, but they also must originate enough loans for them to stay in business. To do so requires more than evaluating real estate in terms of its value as loan collateral. Commercial underwriting also involves evaluating the present & potential profitability of the cash stream from the property &/or the business that is associated with it. This done via evaluation of financial statements and non-real estate ratios derived from them. Originators who prefer not to waste time on impossible funding requests, also do at least some similar analysis.

3. Where to Begin? Analysis of financial statements and business operations, present or proposed, is a complex subject that is more than can be covered in a single tutorial, or even a full course. There is enough to know to an entire degree can be based. It is so complex and critical that even CPA’s generally have special training and liability insurance when they, for example, make written statements/judgments about pro forma financials and the assumptions on which they are based. However, as an originator/affiliate, the goal is to determine whether a funding request has merit. That is, will an existing or proposed income property or business be able to repay the funding, & whether the underlying collateral is adequate if they do not. For that, knowing the items in green, in this tutorial, will be adequate to determine whether your “suspect” is a prospect, or whether they need to “go back to the drawing board.” But, for those who want more in depth knowledge…that is here also.

4. Six key lending questions/issues: • What is the character of the borrower and the quality of information provided? • What are the loan proceeds going to be used for? • How much does the customer need to borrow? • What is the primary source of repayment and when? • What collateral is available ? (Secondary source of repayment) • Is the business/property solvent now & likely to remain so in the future…ie: Will the be enough money to support the debt service even if NOI decreases? $ ?

5. What is evaluated for requests for credit: • Income past, present • Profit past, present; both absolute & as a % of gross income • Balance sheet figures past & present • Cash flow analysis • Pro forma projections analysis $ ?

6. Five steps in evaluating requests for credit: • Overview of the management and operations • Extraction of key information from the financial statements • Choose & create appropriate ratios • Cash flow analysis • Evaluate reasonableness of Pro forma projections assumptions

7. Overview of management and operations • Gather information on: • The business and related industry • Management quality • Nature of loan request • Quality of the data

8. Compare a firm’s financial performance to its own past & its industry as a whole: • Examine the financials and compute common size ratios from its components rather than comparing grapes to watermelons!*** • Compare the subject with industry averages • Compare figures over time (on trend) • Calculate a series of financial ratios that indicate performance and risk • Compare with industry averages • Compare over time *** For balance sheets, to use common size figures, utilize the % of assets rather than the absolute numbers

9. What is Found Where on Statements?A Review of the statements that make up a management report: • The Balance Sheet is a snapshot in time of assets, liabilities and equity. Changes in these things are determined by comparing multiple balance sheets. • The Income Statement (P&L) shows the income & expenses (& profit or loss) over a period of time (mon, quarter, year) • The Cash Flow Statement shows the sources & uses of cash over the same period of time as the P&L. Obviously, it is important to look for the right numbers on the right sheet! You won’t find the actual income on a balance sheet…only how the net income affected the balance during the period since the balance sheet at the period start. Likewise, you won’t find the total assets or liabilities on an income statement, nor the source of cash on the balance sheet!

10. What is on the Balance Sheet? The Accounting Equation: In effect, the Balance Sheet is a detailed report of the Accounting Equation as it relates to an income property or an economic enterprise. Important for most investors is that it gives Net Worth as defined by the underlying assets & liabilities. The effect of normal business operations on assets & liabilities changes equity…but it is also directly effected by equity contributions & deductions. Or: ASSETS - LIABILITIES = (owner’s) EQUITY (a/k/a Net Worth)

11. “Eyeball” Analysis of a Balance Sheet” Analysis that doesn’t require a calculator: • Look at cash…probably the top item in Assets. Compare to cash on the previous sheet, or several previous sheets. Figure average cash per month. Does the cash figure match the bank reconciliation? It should! • If the cash is positive for every statement, that is good. If negative on the current statement, divide by the number of months and it gives an idea of when cash will run out! • Look to see if capital expenditures are consistently large. If paid for with financing, and income drops, it could be disastrous. • Assets dropping from previous sheets? Liabilities increasing? Before you even bother to calculate a ratio, do the assets & liabilities seem out of proportion? • How about equity? Rising? Dropping? Owners forced to contribute to keep things afloat? Or, as they bleeding the company with overly large distributions? • Do the fixed assets seem to generate enough income? • Are accounts payable too high or too low (paying before bills are due or risking credit standing with suppliers)? • Do accounts receivable seem too high (Where’s the money) ? • Are intangible assets (good will, patents, etc) over-valued? • Do increases in payroll tax liabilities indicate they are not being paid? • Does the NOI match that on the Income Statement? It should! • Is Equity about twice debt? That’s a healthy company’s ratio.

12. What is on the Income Statement? We could call this the Profit or Loss equation, as it is the math provided by the Income Statement: subtracting expenses from income to yield the difference, the (hopefully…) operating profit. INCOME - EXPENSES = PROFIT (NOI) >>> or loss!

13. “Eyeball” Analysis of an Income Statement” More analysis that doesn’t require a calculator: • Did Gross Income (Sales) go up or down since the last period? Or, up or down consistently over several periods, possibly indicating a trend? • What about COGS (Cost of Goods Sold) or other expenses? Up? Down? Consistently up or down over several periods? • Are there expenses that are large, but justifiably not likely to recur? Was there income that, similarly, could be considered a “windfall” not likely to recur? • Look at the various figures as a % of gross sales…ratios that are already calculated for you on most income statements. • Do any number just “jump out at you”? • Compile a list of the items that behave like expenses, but which the investors consider “add-backs” which do not reduce NOI in their eyes: depreciation, non-recurring cost, reserves (some lenders), the current debt service that will be replaced with the new funding, etc. • Read CPA’s footnotes & management comments if available.

14. A Note on the Quality of the Statements:“Cookin’ with GAAS” When a CPA has had his hands in the preparation of financial statement, there will usually be an accompanying report which will detail whether this is an audit, a review or a compilation. • An audit is prepared in compliance with GAAS, Generally Accepted Auditing Standards and is the CPA’s assurance, if he can make that assurance, that the report fairly represents the entity’s financial condition. • A Review is less assurance, but is affirmation by the CPA that, based on more limited procedures than in an audit, nothing was found with casts doubt on the reliability of the report. • A Compilation includes no accountant’s statement at all. It is merely what it says, a compilation of the figures provided to the CPA, but done in a generally accepted format. Lenders don’t usually insist upon audited financial statements, but it is far from unheard of. Whether they are requested will depend upon the loan size, the comfort of the lender with the borrower, the age and reputation of the borrowing entity, etc.

15. Ratio analysis: Separating fantasy from reality by examining: • Liquidity and activity ratios • Leverage ratios • Profitability ratios

16. Liquidity and activity ratios • Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. • Two frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio. These two ratios compare current assets to liabilities, but the Quick Ratio excludes inventory which may not, in & of itself, be particularly liquid. The Quick Ratio, for that reason, is often referred to as The Acid Test. Part of the activity ratios relate to how quickly accounts receivable are collected and how quickly assets are turned over thru sales.

17. Liquidity and activity ratios • Net Working Capital = CA - CL • Current Ratio = CA / CL • Quick Ratio = (Cash + A/R) / CL • Days Cash = Cash / Avg. daily sales • Inventory Turnover = COGS / Avg. Inv. • AR Collection (Days A/R) = (A/R) / Avg. daily sales • Sales to net fixed assets = Sales / Net fixed assets A successful firm is both active & liquid Abbreviations: CA = Current Assets CL = Current Liabilities A/P = Accounts Payable A/R = Accounts Receivable COGS = Cost of Goods Sold

18. Leverage ratios • Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt. • Common leverage ratios compare debt to assets & debt to equity. • The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and a lender version is called the Debt Service Coverage Ratio.

19. Leverage ratios • Debt Ratio = Debt / Total assets • Debt to tangible net worth = Debt / Tang. NW • Times Interest Earned = Earnings as multiple of interest = EBIT / Int. exp. • Net Fixed Assets / Tangible NW • Dividend Payout % = Dividends paid out / Net profit A successful firm minimizes debt as a percent of its assets & Net Worth, increasing leverage Abbreviations: EBIT = Earns before tax & interest exp. NW = Net Worth

20. Profitability ratios • Gross Profit Margin = (Sales – COGS) / Sales • Return on Equity (ROE) = Net income / Total equity • Profit before taxes to net worth = Profit before taxes / Tangible net worth • Return on Assets (ROA) = Net income / Total assets • Profit before taxes to total assets = Profit before taxes / Total assets • Asset utilization (AU)= Sales / Total assetssometimes referred to as asset turnover • Profit margin (PM) = Net income / Sales D = “delta” the sign for “change in…” • Sales growth = DSales / Last period’s sales • Income taxes to profit before taxes = Reported income tax / Profit before taxes A successful firm maximizes net profit on its gross profit, sales & assets & increases its net profit percentage over time

21. Sources and uses of cash • Sources of cash are: • Increase in any liability • Decrease in any non-cash asset • New issues of stock • Additions to surplus • Revenues • Uses of cash are: • Decrease in any liability • Increases in any non-cash assets • Repayment / refunding of stock • Deductions from surplus • Cash expenses, taxes, dividends

22. Understanding sources and uses of cash as shown on the balance sheet • A way to look at the balance sheet is in terms of it showing the "sources" and "uses" of cash. Liabilities and net worth are sources of cash: They represent debt owed to creditors who have supplied cash or its equivalent. Assets are a use of cash: The company uses cash to purchase assets in order to make a profit. • Assets are a use of cash: • Liabilities are a source of cash: • Revenues are a source of cash: • Expenses are a use of cash: • Sum up each part

23. Cash flow statements The cash flow statement explains the reasons for changes in the cash balance, showing sources and uses of cash in the operating, financing, and investing activities of the firm. Ie: Cash in from the NOI shown on the income statement Ie: Cash in or out from the sale or purchase of long-term liability, like real estate Cash in or out from borrowing or paying loans

24. The sections in cash flow statements: • Operations • Includes income statement items and all current assets and current liabilities. • Investments • Includes all long term assets • Financing • Includes all long term liabilities and equity (except retained earnings) plus cash dividends paid. • Cash • Total of the above, but must equal the actual change in cash and marketable securities.

25. Cash flow statements from accrual information Because the cash flow statement is a cash-basis report, it cannot be derived directly from the ledger account balances of an accrual accounting system. Rather, it is derived by converting the accrual information to a cash-basis using one of the following two methods: • Direct • Converts the income statement into a “cash based income statement.” • Begins with net sales and adjusts for changes in balance sheet items. • Indirect • Adjusts net income for non-cash charges and changes in balance sheet items.

26. Projections of financial condition • Pro Forma projections of the borrower’s condition reveal: • How much financing is required. • When the loan is expected to be repaid. • Use of the loan proceeds. • Pro Forma Projections • Determine critical and non critical assumptions. • Use industry projections, internal projections and judgment to determine sales projections.

27. Pro Forma: Income Statement • Salesfuture = Salespresent x (1 + salesincrement) • COGSfuture = Salesfuture x COGS % of Sales • Sell. Expfuture = Salesfuture x Selling Exp. As a % of Sales • G&A Expfuture = Salesfuture x G&A Exp. % of SalesGen & Admin expense is non-production expense • Int. Expfuture = (Bank debtfuture x rate on bank debt) + (L.T. debtfuture x rate on L.T. debt) One cannot argue with the above formulas, but whether the pro forma figures they generate are believable, or not, depends up the choice of increment, %’s & rates that are inserted into them. And that is where the the difficulty & uncertainty enters the equations. When possible, industry standards may be available. But that is not the case in regard to new or innovative enterprises.

28. Pro Forma: Determining the “Plug Figure” The difference in projected asset base and total funding without new debt determines additional credit needed or the Plug figure. • When projected Assets > (Liabilities + Net worth) → Additional financing is required OR (notes payable plug): Notes payable = A – (L + NW) • When Assets < (Liabilities + Net worth2005) → Surplus cash, invest (marketable securities (plug): Mkt. securities = – (A – (L + NW))

29. Pro Forma: P&L (Income, Expenses) • A big difficulty in P&L pro forma’s is predicting income growth, even if the entity is already in existence. It is even more difficult with a startup. These issues are less of a problem in regard to income-producing real estate, as market experts exist whose opinions and assumptions are trusted by the lenders who fund such projects. That is not the case with entities that are startups in innovative, untested ventures. • Sales growth will determine growth in receivables, inventory and profit. The difficulty in the pro forma assumptions is whether the ratios between the sales and the other figures will vary with that growth. “Quick and Dirty” pro forma’s often neglect to account for changes in those ratios. Or, they have no support for either the ratios they postulate or the changes the predict. • Net Income varies directly with sales in a stable environment, but the issue for the pro forma author is to justify that stability, especially if the entity is either a startup or predicting growth that may require a period of time to stabilize.

30. Various financial projections assumptions that should be examined for reasonableness: • Gr. annual sales will increase as projected? • Cost of goods sold a reasonable % of sales? • Selling expenses a reasonable % of sales? • Gen. & Admin expenses a reasonable % of sales? • Depreciation (Appropriate? Constant?) • Noninterest expense reasonable? • Interest expense is reasonable % of bank debt and of other long-term debt? • Income taxes a reasonable percent of earnings before taxes? • Income tax payable increasing along with NOI? • Are dividends reasonable or hurting the company OR less than required under tax law?

31. More financial projections assumptions that should be examined for reasonableness: • A/R collection going up or down? • Inventory turnover, if applicable, increasing or decreasing? • Days AP increasing or decreasing?

32. Managerial analysis of options to turn around distressed income properties: • Occupancy decreasing? Can be turned around with new tenant bonuses? • Difference between average rent & market rent increasing? • Delinquencies increasing? • Utility bills increasing? (could indicate water leaks, dirty air filters, dirty furnaces; or options to change energy suppliers; or install solar, or energy-efficient windows, door seals, etc) If master-metered, is sub-metering legal & feasible? • Paving cracking? Can it be sealed rather than replaced? • For comm’l tenants: Are net rents, per tenant, correct based on net space leased? • Expenses decreasing while NOI is increasing? • Management expenses reasonable? • Service expenses reasonable? On-site handyman/tenant feasible? • Advertising adequate or excessive? Replaceable with referral fees? • Can collections be increased with auto-withdrawals? • Is conversion to gated community appropriate…Will higher rents be possible to offset the cost? Will it significantly decrease vandalism or increase security? • If major rehab is needed, are municipal grants available to accomplish it? • Will a cash-out refi bring higher returns than the loan’s cost? • Will cosmetic (paint, carpeting) rehab bring an adequate return? • Additional services economically feasible (game room-vending machines-laundry)? • Are deposits appropriate for pets, TV dishes, commercial vehicles? • Possible to require fees & proof of insurance for the likes of ice cream vendors? • Can effective screening reduce dead-beat, criminal or destructive tenants?

33. Advanced Pro Forma Analysis • The following pages are here for study at your option, but they will not be covered in the certification exams. • Included is the step by step process of converting accrual accounting data into cash-based cash-flow statements. In general, we assume this is done for us in the statements we are given. • These are some of the additional ratios that an underwriter would use in the analysis of pro forma financials, but we do not expect that an originator has either the time or the need for this level of investigation when merely pre-qualifying a prospective funding applicant.

34. Converting the income statement into a cash based income statement • Operating: • Cash sales: • Total up Net Sales • Deduct  Accounts receivables • = Cash sales • Cash purchases (negative value): • Deduct COGS • Deduct Inventory • Add in  Accounts payable • = Cash purchases • = Cash gross margin Read “” as “the change in”

35. Converting the income statement into a cash based income statement (continued) Operating (continued): • Cash operating expenses (negative value): • Deduct Operating expenses • Add in Non-cash charges (dep. and amortization.) • Deduct  Prepaid expenses • Add in  Accruals • = Cash operating expenses • Other expenses and taxes: • Deduct Other expenses + Other income • Deduct Reported taxes • Add in  Income tax payables and deferred inc. tax • = Other expenses and taxes • = Cash flow from operations (CFO)

36. Cash based income statement (cont.) • Investing: • Deduct Capital Exps. =  Net fixed assets + depreciation • Deduct  Other long term assets • = Cash used for Investing. • Financing: • Deduct Payments for last periods current maturity debt • Deduct Payments for dividends • = Payments for financing • Add in  Debt + EOP CM L-T debt • Add in New stock issues • = External Financing • = Change in cash and marketable securities

37. Pro Forma: Balance Sheet (Assets) Associate balance sheet items with sales. • ARfuture = Ave Days A/R x Average Daily Salesfuture • Inventoryfuture = COGSfuture / Inventory turnover Capital expenditures from the capital budget: • Gross fixed (GFA)future = GFApresent + Cap. Exp.future • Accumulated depreciation2005 =Acc. present + depreciation exp.future Determine appropriate turnover rates from historical trends or industry averages.

38. Pro Forma: Balance Sheet (Liabilities) Trade credit may be tied to inventory growth, thus accounts payable tied to inventory growth: • APfuture = Ave Days AP x Avg. Daily purchasesfuture = Ave Days AP x ((COGSfuture + DInv. future) / 365) Principal payments on debt can be obtained from the capital budget: • LTDfuture = LTDpresent + New LTDfuture – CM LTDfuture • Term notes (TN) future = TNpresent + New TNfuture – CM TNfuture Note: CM = Current maturity

39. Pro Forma: Balance Sheet (Equity) Balance sheet definitions: • Retained earnings (RE)2005 = REpresent + (NIfuture – Div. future) • Stockfuture = Stockpresent + New stock issues Note: an accounting adjustment is only needed when adjustments have been made to retained earnings. NI = Net Income

40. End Reading & Analyzing Non-RE Business Ratios & Financial Statements for Commercial Funding Pre-Qualifications & Underwriting END