Business of Agriculture: The Importance of High-Quality Financial Reports
By Stephen Book
The Business of Agriculture series covers finance, accounting and other business topics to help both beginning farmers and ranchers as well as experienced operators. Stephen Book is VP Credit Officer for Capital Farm Credit. He has been with the Farm Credit System for ten years, and is based in Lubbock, Texas.
It stands to reason that a financial institution determining whether or not to lend money to a business operation needs to have a clear and accurate understanding of how that operation is performing. The balance sheet and profit and loss statement -- P&L statement, also known as an income statement -- are two key financial reports that convey this critical information so a lender can assess the financial condition of a business. With this and other information in hand, such as tax returns and statements of cash flows, lenders can accurately assess risk and make informed credit decisions, not just about whether to make a particular loan but also how to structure it.
A balance sheet gives a summary of the assets, liabilities and equity of a business at a particular point in time. In other words, it details what a company owns, what it owes and how much has been invested in it. The P&L statement shows the company’s revenues and expenses during a given period – what money came in and what money went out. The information provided in both of these financial reports should be current, adequate and reliable.
For the balance sheet, being current will vary based on the type of loan being sought: for a term loan, such as a real estate loan, generally the balance sheet should be no more than six months old; for an operating loan it should be as close to the renewal date as possible. If more than one balance sheet is being provided, they should all cover the same time period (i.e. all dated December 31, and represent consecutive years). The profit and loss statement should encompass a full operating cycle (typically, but not always, a calendar-year); if no tax returns are being provided to support the loan application, borrowers may need to provide up to three years of P&L statements.
To be adequate, balance sheet information needs to be detailed enough that it can be verified by the lender. For example, current, intermediate and long-term assets should be segregated into industry-standard categories, such as equipment, livestock and real estate. P&L statements should include a detailed list of income and expense items, preferably either in a spreadsheet or QuickBooks format.
Balance sheet information reliability is determined primarily through verification, such as checking credit bureau reports and reviewing association records to compare with balance sheet totals for loans outstanding. For the P&L statement, the lender will conduct testing, such as comparing the submitted P&L with tax returns. The best way to assure reliability of financial statements is to have them audited, reviewed or prepared by a Certified Public Accountant (CPA). Particularly for larger or more complex loans or business operations, involving a CPA in preparing all of your financial reports, including tax returns, will go a long way to ensure their reliability and accuracy, not just for your lender but for your own peace of mind.
The amount of financial information needed will vary with the loan size, risk and complexity – as the size of the loan request increases, or the complexity of the operation being financed increases, more detailed and expansive information may be required. In addition, for very large and very complex transactions, audited financial statements may be required. This can represent a significant expense for the borrower, a justified expenditure for larger loan requests.
In addition to showing a lender the condition of a business, financial statements provide farmers and ranchers with important information on how their business is doing, and can guide their strategic operational decisions. The discipline of generating and reviewing these reports, even if no new loan is being sought, can lead to informed business decisions and long-term success.