- by Joel Pruis
Application Requirements: Financials or No Financials – That is the question!
Probably the first debate with information requirements is whether or not to collect financial statements on the business. There has been much heartburn by the commercial lending traditionalists with the common practice not to collect financial information for a certain segment of the small business applicants. Great relief was felt by these traditionalists after the 2008 small business portfolio poor performance of some financial institutions providing the necessary foothold to reinstitute the collection of financial statements on all applications.
Unfortunately, as with many of the changes made to small business lending over the past three years, the mandated use of financial statements is not going to prevent the banking industry from experiencing problems in a small business portfolio. Rather it is likely to prevent a financial institution from being successful in the small business lending segment. Let’s take a look at a couple of trends that lead me to this conclusion:
Application Turnaround Time
We see that we have almost doubled the amount of time it takes to process a small business application from 2006 to 2010 with the greatest increase in turnaround time coming from credit unions followed by the two largest asset categories $2B - $20B and greater than $20B. As we discussed in previous posts, the result of the increased turnaround time and higher application requirements was greater applications going to the financial institutions with assets of $500 million or less.
From a purely credit perspective, the response may be “so what if it takes us longer to process and we see a lower application volume?” Two realities quickly come to play with this statement – longer and more complicated processing means higher cost and lower application volume is not an option for anyone that has been in the banking business over the past few years. Efficiency and volume must be considered when we are talking about the future strategy around small business lending.
I am not advocating an “open the floodgates” approach that pursues efficiencies at the expense of quality. Not at all. If there are any of my fellow former Bank One brethren out there, we all know that it is soundness, profitability and growth – in that order. The reality is that with small business we must not be quite as “sound” as we are in the commercial segment so that we can be “profitable”. We cannot take the approach that any charge off is a bad charge off. We still operate in a for-profit model and profits are based upon revenues minus expenses. If our operating expenses related to small business exceed the revenues obviously we are not profitable. If we are able to save significantly on the operational expenses while recognizing a manageable and expected amount of charge offs, we should be able to generate a profitability model that makes sense. (Hang in there with me - there will be much more to come on the topic of decisioning strategies that allow us to manage risk and anticipate expected losses in future posts.)
Other factors to consider are the accuracy and reliability of the financial information supplied by the small business applicant. Let’s use an analogy to discuss the point further -
Let’s say that you are working on getting in better shape physically. One of the factors that you likely need to consider is your overall weight. Maybe you need to lose a couple of pounds or you would simply like to maintain your weight but “redistribute” the body shape a little. Regardless of your ultimate objective, you probably will want to weigh yourself on a regular basis as one of the measures of your success and determination of future actions needed to achieve your goals. Problem is that your scale shows that you have lost 10 pounds one minute but if you step on the same scale just 2 minutes later it shows that you have gained 5 pounds. Try as you might, you just cannot get the scale to be consistent or accurate. What are you to do? (besides buy a different scale). There are other factors or measurements that you could take to indicate whether you are succeeding. One indication might be that your pants are getting loose. You measure your waist with a tape measure and you are seeing the measurements getting smaller and smaller. Remember the Special K® “pinch an inch” campaign? That might be another measurement. While none of these may be as precise as if you were to have an accurate scale to measure your weight, the use of these other techniques would definitely be a strong indication that you are, in fact, losing weight.
For those who have worked with the type of financial statements received from a small business owner I am going to go out on a limb and state the following:
- If the balance sheet actually balanced – this is above average
- If the retained earnings foot from one year to the next (without an unexplained adjustment) – this financial statement gets pinned up on the wall with a gold star!
The reality of small business financial statements is that at the low dollar requests they are typically unreliable and incomplete. Incomplete from the perspective of either being on a cash basis (thus excluding income yet to be received and expenses yet to be paid) or unreliable as they are not completed using GAAP (Generally Accepted Accounting Principles). Here’s a true example from my personal experience:
- Received a request from a client for an increase in his line of credit
- Reviewed his financials indicating total accounts receivable of over $300,000
- Granted the increase in the line
- At closing I questioned the client on how he was fully supporting the working capital needs with the large balance of receivables outstanding
- His response – “Oh, I record the receivable as soon as I receive the contract. I haven’t completed all those contracts yet.”
Fortunately for me, the other characteristics that were considered (time in business, past line/payment performance with the bank, total relationship, etc) all pointed to this being an acceptable risk (which it was). The point is that the reliance on the financials to determine debt capacity for the smaller dollar segment is at best unreliable. As with the weight loss program noted above, if the information is unreliable, I should not depend upon it for my decisions.
I am not advocating the omission of financial statements from all applications in the small business/business banking segment. Rather proper segmentation for application requirements based upon reliability, impact on credit quality and overall processing costs. Bottom line is what is the cost benefit analysis for the inclusion of the financial statements in the application requirements?
Going back to our overall segmentation strategies for determining the small business segment, we are going to use the 80/20 rule here as well. Within the small business/business banking segment approximately 80% of the applications (the smallest dollar requests) will account for only about 20% of the total dollars requested. Based upon the high volume/low dollar in this segment, the overall cost benefit simply does not exist to substantiate the collection, spreading and analysis of financial statements.
Something else to remember is that when we are reviewing a small business application, the lack of financials at initial application submission does not mean we can never collect financials. If we define a completed application at a lower dollar amount to be complete without financials, obviously we have to process the application and render a decision in the prescribed 30 days. However, if the receipt of financial information is likely, let me repeat: LIKELY, to change our decision from decline to approve, by all means, ask for the financials. If no financial information is received in the 30 day window, the application is declined. If it is received, we may be able to alter our initial decision of decline to approve. I again emphasis LIKELY as we all can make the client go through the exercise as a “feel good” measure to collect the financials and make one last effort to see if there is any way to approve the application. Such an approach, however, needs to be based in reality and use the expertise of the lender/underwriter to assess the likelihood. Too often in the current climate I have found lenders or underwriters requesting financial information in an attempt to be “thorough” in their analysis. If doctors took this approach, the initial diagnosis of the flu or a virus would never be made until we actually ran blood tests, gathered cultures and performed other procedures to properly and specifically identify the specific ailment all to end up with the same remedy of antibiotics. The approach would merely serve to delay the known response, cost more money and cause the patient to suffer longer than required. Similarly, the collection of financial information is likely to only confirm what the underwriter/lender is already convinced is the case and cause delays, baseless hope for the applicant and ultimately higher costs for the financial institution.
Overall, the collection of financials or not does not mean we avoid any portion of financial information in our application process. Some business financial information is still needed in the application process such as total annual sales and cash balances maintained by the business but these numbers do not require the collection and spreading of financial statements. Rather the application form itself can request this information and make it available for underwriting/analysis. Total sales and overall profitability (was the business profitable or not?) are two items that should be collected on every application and tell us much for the underwriting process. We will talk about the underwriting more next time.
Bottom line - you can let go of financial statements for a segment of your small business applications. Be prudent and get the pendulum back to the middle.
Next month – we'll cover underwriting and data requirements. In the meantime, leave a comment and let me know your thoughts / approach / or just say “hi, I remember that pinch-an-inch campaign”. I would like to learn more about my audience.