Jeff Judy

Jeff's Thoughts - May 6, 2015

History Matters, But Which History?

Credit is about predicting the future. Risk management means coming to a decision about the likelihood that a borrower will repay a given loan, and about taking steps to make that repayment more probable.

What do we use to peer into the future? The borrower's recent past, for the most part. Financial statement analysis, cash flow analysis, and broader borrower and credit analysis rely on the borrower's history to give us clues as to what might happen going forward.

If you have been reading this e-zine for a while, or you have been in any of my training sessions or attended my conference presentations, you probably won't be surprised when I say there's a tendency to give too much weight to the patterns of numbers that go into these analyses.

For example, financial statements may show consistent sales growth. Or cash flow analysis may suggest that more cash has become available to the borrower in the last year or two. But if you (or the borrower) cannot explain the patterns those numbers show, they may not mean very much when it comes time for repayment.

I see financial statements and cash flow numbers as snapshots, capturing the state of the borrower at a particular point in time. Those numbers change from snapshot to snapshot, and exploring the reasons behind those changes gets at the real point of credit analysis -- understanding borrower management!

Businesses experience new opportunities and threats all the time. A new competitor steps into the marketplace, or an existing one goes away. Cost of goods skyrockets or plummets. Legislation changes the rules of the game, for good or ill.

It is the responses of borrower management to these threats and opportunities that lead to the numbers we so love to crunch. And one of the key questions I always liked to pursue with my customers was, "Does management understand the relationship between their management decisions and their financials?" In other words, can they explain the changing numbers, and, to some extent, manage their numbers?

It's great to see an increase in sales over the last two years. Does the borrower know why sales are up? Or are they just enjoying a good run without really understanding where it came from?

If gross profits are improving, is it because they have pursued sales volume or because they have attacked costs to boost profit margin? Is the change a result of management action, or an artifact of market conditions?

If cash flow is a little squeezed recently, has management attempted to adjust their practices (inventory, accounts receivable, etc.) to improve it? Or do they simply jump to the conclusion that they need a loan until cash flow "rights itself"?

I'm looking for the link between financial figures and management behavior. The history of management's actions -- including timely provision of statements, cooperation during the application process, and so on -- is more important to me than graphing the history of the numbers.

Numbers and financial patterns are great conversation starters when you want to probe management's competence and commitment. The most effective risk managers are careful never to let the conversation end at the numbers.