Jeff Judy

Jeff's Thoughts - December 17, 2014

Inputs and Outputs in Borrower Analysis

Borrower analysis is something we think of very much in "input-output" terms. We input numbers and get reports that give us new numbers. And we sometimes think of those report numbers as the key "outputs" in the process.

Take Financial Statement Analysis, for example. We collect the statements the borrower provides and "spread" them to generate interesting ratios and perhaps some nice graphs. And we may believe these "outputs" offer the answers to our questions about whether the potential borrower is creditworthy.

While FSA reports may be outputs of the number-crunching process, it is a mistake to think of them as outputs of the decision-making process. At best they are "intermediate outputs": they are the results of some numerical analysis, but they also are inputs to the broader analysis process.

What those new numbers represent, in reality, are transformed inputs. They are a way of translating the numbers the borrower provides so that they can more easily be compared with standards, with our experience with other borrowers, with our expectations.

It is a little like talking about the weather. I could tell you a certain day is "warm" or "breezy" or "wet". But your idea of "warm" might not quite the same as mine (winter here in Minnesota vs. winter in Florida).

So turning those statements into numbers -- temperature, wind speed, inches of rain -- makes it a lot easier for you to decide whether you agree with me. The true output is your agreement or disagreement that "it is a warm day", a judgment based on your experience. The numbers are just clearer inputs to that decision process.

In borrower analysis, then, the numbers we input into our algorithms lead to new, more informative numbers. But they should also help us see "behavioral outputs" that are crucial contributors to a sound judgment about the borrower's future.

I think of the results of financial statement and cash flow analysis as descriptors of what the business's owner or management team is facing. Number crunching reveals their resources, their challenges, even their habits and tendencies.

And one of the most interesting, and sometimes most neglected, "outputs" of analysis is the management response. In other words, given the picture painted by the number-crunching, what action is management taking to improve those numbers? What indications, in management behavior, can we find that the management team understands their financial situation?

In weather terms, are they taking off a jacket when we think they should be putting on a coat? Do they see the meaning of their current status, and have a plan to travel a path to a better status?

As an industry, we like numbers. And sometimes the numbers are so bad, or so good, that they do tell the story by themselves.

But that happens a lot less often than we think it does! We cannot fully understand those input numbers, even the processed ones, until we evaluate the management responses they provoke. And then we must make a judgment about whether those responses are the kinds of responses we welcome from our business customers.