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Financial statements and Fundability

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Disraeli once said that “there are three kinds of lies: lies, damned lies, and statistics.”

January 12, 2009
Author: Derek Rowley

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In business, some of the “statistics” that can tell such damning lies are the numbers found on company balance sheets and income statements. Too often, the reality is not accurately reflected in the numbers. Accounting is not intended to be a creative art, but in the hands of the right practitioner or aggressive entrepreneur, the accounting numbers can paint almost any type of picture.

Borderline – or worse – companies can be made to appear to be profitable.Profitable companies can be made to look break-even or even appear to have losses.But, there is a point at which the numbers – however they are painted – can impact your lend-ability as a company.

If you are like many of our clients, you are using your Nevada corporation or LLC for a specific strategic advantage or benefit, it could be more likely that you could be using business practices that could negatively impact your lend-ability.

To illustrate, consider a fictional Nevada company as an example: Tajax Industries is incorporated in Nevada and owned by James Smith. The company imports raw materials that are sold to manufacturing companies in California. In order to take advantage of a new market opportunity, Tajax needs additional funding in order to finance the purchase of additional product for importation. James applies to an SBA lender bank for the financing, and provides all the documentation, including financial statements and tax returns.

The bank looks at the numbers and rejects the loan.They determine the business is marginal at best, and is too high of a risk to qualify for the funding.Mr. Smith objects, arguing that the business is a real money maker.

Here are some of the things the bank might not have considered – some “damn lies” that were hidden by the statistics on the financial statements:

1. Mrs. Smith does all the accounting for the company. A replacement would cost less than half of the salary paid to James’ wife.

2. James Smith is paid a salary that exceeds fair and reasonable compensation.

3. The business provides a lot of perks, paying for automobiles, insurance, medical expenses, travel, etc.

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4. The Smiths have a son away at college, who, despite not providing any actual services for the company, continues to draw a salary.

5. Mr. Smith owns property in Nevada that Tajax leases, and pays double the fair market value in rent.

6. All the financial reports are made on a cash-basis. So, it doesn’t reflect sales based on credit, leaving out all the accounts receivable.

The bank does not look at these factors to make adjustments. So, they determine that the business operates on a rate of return of 7.5% on investment capital. Their research tells them that a business of this type and size should provide almost 20% return. As a result, the loan is still considered a high risk, and value the business at worth $650,000. No loan.

In another scenario, the same company hires a qualified accountant who looks at the business entirely differently. He prepares a set of financial statements that reflect a number of adjustments to give a clearer picture of the reality of the business. The rent is adjusted to fair market value; salaries are adjusted to fair market, and “reasonable”; the son is removed as an employee; the financials are reported on an accrual basis, significantly increasing the value of the business, and; the perks are adjusted to remove personal expenses.

After these adjustments, the financials tell an entirely different story. Now the company shows a 19% rate of return on capital, the business is valued at $1.3 million, and the loan is approved.

So, when trying to access business credit, the “statistics” on your financial reports might be telling a different story than you expect. Think through the “damned lies” that might be hiding in your financials before you submit loan applications to lenders.

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