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In this article, a former private banking officer and financial planner and a quality assurance manager for a scientific software firm describe the use of individual borrower or guarantor financial data to construct calculated net worth figures. These figures are then compared with borrower-provided net worth to determine missing components of cash flow, such as living expenses. By identifying the missing elements, true borrower cash flow can be determined and debt-servicing capability evaluated.
Most individual loan applications, individual guarantor applications for corporate loans, and even small business loan applications usually include estimated market value financial statements. Unlike audited or reviewed historical cost corporate financial statements, the level of reliability of these personal statements is questionable. The major document adding credibility to each loan application is the federal income tax return. Blending the tax return data with the financial statement data to reconcile the differences in net worth between statement dates assists the loan officer in the analysis process by verifying true cash flow. This cash flow information determines the borrower's ability to repay existing and newly requested loans. Without this information, loan decisions concerning individual borrowers cannot be made on a reliable basis.
Tax return data, however, do not provide all components of an individual's cash flow. A reconciliation of net worth differences considering calculated cash flow helps determine whether all pertinent financial data have been provided and present a complete picture of both cash flow and net worth.
A reconciliation of market value, statements can be accomplished by using two successive financial statements and an appropriate tax return together with selected other information. The financial statements do not have to be successive calendar year-end statements, although the reconciliation is easier if they are. Also, they do not have to be prepared by a certified public accountant. And by using the techniques in this article, the statements need not be one year apart. Reconciliation between any two statement dates is possible by following the recipe in the sidebar on pages 20-21.
The approach has five steps:
1. Start with prior net worth.
2. Calculate net cash flow.
3. Calculate and evaluate changes in noncash assets.
4. Calculate liability changes.
5. Construct a new net worth from these calculated values and compare this calculated net worth with the borrower's subsequent financial statement net worth.
The end result is a determination of the consistency between income, expense, and financial statement values supplied by a borrower in a manner that helps ascertain whether the cash flow is reasonably true and accurate. Let's review each step separately.
1. Start with Prior Net Worth
Examining the construction of the borrower's initial financial statement and verifying the significant line items are worthwhile first steps. Personal and other market value statements list assets according to their current value at the date of the statement rather than at the historical cost when they were acquired. Liabilities are similarly listed, and the simple difference between total assets and total liabilities is called net worth rather than equity.(1)
No accounting is kept of the changes in historical account values over time owing to depreciation or otherwise, as is done with historical cost statements. As such, the American Institute of Certified Public Accountants (AICPA) does not call these personal asset and liability listings balance sheets but rather personal financial statements or statements of financial condition. Unlike the equity of corporate balance sheets, the changes in net worth values can not be easily reconciled between statement dates.
Financial Statement Construction
Personal financial statements properly list assets from most liquid to least liquid.(2) The most liquid assets represent the most reasonable secondary source of repayment for a loan.(3)
Liabilities should be listed in order of maturity.(4) It is helpful for a lender to see the short-term, or within one-year, liabilities subtotaled. Although current AICPA convention disallows classification of current liabilities for personal financial statements, lenders find such segregation helpful for their own purposes.(5) If a lender knows the level of existing obligations due within one year (including progress payments due within one year on longer term obligations), the ability of the borrower to service the debt on a proposed loan in its first year becomes readily apparent. This comparison can serve as a screen to determine which loans justify further consideration. If first-year debt service appears impossible from given information, continued pursuit of such a loan is futile.
Current or market values allow a lender or other analyst to determine potential collateral or other support available for loans being considered.(6) These listings are practically determined by the borrower's best guess at value. Exceptions are cash, cash equivalents, and such readily marketable items as market-listed stocks and bonds. In these cases, bank and brokerage statements, as well as closing prices of the securities markets near the financial statement date, are typical sources of market value information. Appraisals are used for some assets, but appraisals typically are expensive and not provided frequently. Depending on the asset, appraisals more than a year old are not reliably accurate. When assets have been recently acquired, the arm's length transaction is often used to provide market value.
Erratic Statement Dates
Market value financial statements are most often constructed as of odd and uneven dates rather than prepared on a regular reporting cycle, such as quarterly or annually. Usually, individuals do not report as often on a situation intimate to them. Frequently, the financial institution's request to substantiate and document a loan application drives the need to report. Dealing with these uneven financial statement dates requires that the associated tax return cash flow …