Avoid “Dumbing Down” The Conversation, Understanding The Financials Elevates The Conversation
I recently took on a new client and in our first meeting, The Boss expressed how frustrated he was with his bank. I asked, “How so?” The Boss said their line-of-credit (LOC) was too small and every time he went to the bank asking to increase his LOC, they routinely asked for a profit and loss statement and a balance sheet. Soon afterward, the bank refused his request. I asked The Boss if he ever asked his banker for a reason, and he said “No, he was too frustrated”.
I looked over his profit and loss statement (P&L) and asked to sit with The Boss to answer some questions I had. Frankly, the P&L was a mess. The Boss was a great technician but a poor bookkeeper. He tried his best to input the information to keep the P&L up to date but his day-to-day duties often won out over accurately inputting financial data. We spent hours trying to organize the P&L according to General Accepted Accounting Principles (GAAP), a term The Boss did not understand until we started working together. We isolated his profit centers and calculated a gross profit per center. We separated the direct costs and the indirect costs, putting the indirect costs “below the (gross profit)line”. We structured the P&L using the Matching Principle from GAAP to show a true performance per month. The separating of materials into the COGS line of the P&L and putting the balance purchased and not used in that month into the inventory on the balance sheet helped to stop the fluctuation of gain-loss between months. I worked with The Boss to continue to improve the P&L’s accuracy month over month.
The balance sheet was another challenge. Separating the current assets and liabilities from the long-term assets and liabilities was our first task. I explained the reason for this because the bank will want to calculate the current and quick ratios to determine the company’s cash flow position. We validated the inventory to identify “frozen cash” and the amount of dead inventory the company was carrying. The Boss received a crash course in understanding how the account receivables aging report, days in inventory, and The Bosses’ decisions affected cash flow. The credit card balance was high and The Boss explained that, without a LOC, he was forced to use the credit cards more than he wanted. This is typical of most business owners in a tight cash position. This all did not happen in a day and it would not be fixed in a day. The Boss had homework that spanned months before we got the financials good enough to present to the bank again.
The Boss and I role-played what the conversation would be like when his banker saw the updated financials. The Boss and I calculated the same ratios a credit analyst at the bank would calculate so we would know where we were strong and where we needed work. The goal was to elevate the conversation between the banker and The Boss. In some cases when a banker realizes The Boss doesn’t understand the financials, the conversation is “dumbed down” to a level The Boss will understand, but this dumbing down does not offer the banker a lot of confidence in The Boss or the company.
The first step was to get the P&L and balance sheet accurate and set up according to GAAP. The next step was to calculate the ratios used by the bank to determine the credit worthiness of the business. The third step was for The Boss to understand how to best present his company to the banker so the bank has confidence The Boss knows what he is doing. If you think about it, a bank is a business like any other business on Main Street. The bank leases money (the loan principle) to a business, and they expect the principle back at the end of the term. In a way, it’s similar to leasing a car from Avis at an airport. Avis wants the car back! The bank wants the principle back. For every dollar the bank leases to The Boss, The Boss must pay interest. This interest is the bank’s profit. The bank does not want The Boss to pay back the interest from the principle The Boss received from the bank. You cannot borrow a dollar and pay back the principal and interest from that dollar. The interest must be paid back from operating profits. The way The Bosses’ financials were prior to us working together, there was no way the bank could tell what the true operating profits were, so they elected not to loan The Boss any funds. Once The Boss showed the bank accurate financials with a healthy operating profit, the bank can consider loaning The Boss more money. Understanding the financials elevates the conversation and allows The Boss to fully participate in the discussions surrounding his company’s financial performance.