List Of Figures... Xiii Acknowledgment... Xviii Introduction...Xix The Commercial Lending Decision Tree...Xx

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1 Contents List Of Figures... Xiii Acknowledgment... Xviii Introduction...Xix The Commercial Lending Decision Tree....Xx Section 1 Understanding Business Borrowers Chapter 1: Business Sectors and Operating Cycles...1 Introduction....2 Relationship to the Commercial Lending Decision Tree....2 Operating Cycles...3 Operating Cycle Purpose...3 Agricultural Businesses...4 Manufacturers...5 General Characteristics...7 Wholesalers...7 Assessing the Risk of a Wholesale Borrower...8 Retailers...9 Evaluating a Retailer s Financial Statements...10 Service Businesses Financial Statements of a Service Business...11 Other Service Related Businesses...12 Construction Businesses Construction Industry Financial Risks Evaluating the Construction Business Financial Statements Operating Cycle Application...16 Analyzing the Financial Data...16 Evaluating the Risks...17 Summary...18 Questions for Discussion Exercise Application to Dry Supply Background...19 Instructions...19 Exercise Chapter 2: Why Businesses Borrow...21 Introduction...22 Relationship to the Commercial Lending Decision Tree Cash Flow Cycles...22 Understanding Cash Flow Cycles...23 Uses of Cash...23 Sources of Cash Capital...26 Trade Credit...28 Accruals...29 Reduction of Credit Sale Terms...29 Long-Term Uses of Cash...30 Long-Term Sources of Cash...32 Reasons Why Businesses Borrow...32 Borrowing Needs By Business Type or Industry General Borrowing Needs by All Businesses...35 iii

2 Borrowing Cause Vs. Purpose (Use of Funds) Typical Borrowing Causes...35 Types of Borrowing Arrangements Borrowing Arrangements Offered by Banks Special Commitment Loan Operating Line of Credit...36 Standby Letter of Credit Term Loan Lease Financing...38 Matching of Purpose to Repayment Sources...39 Competing and Complementing Financing...39 Full-Range Competitors to Banks Brokerage Firms...40 Credit Unions...40 Competitors with Limited Products...40 Commercial Finance Companies...40 Factoring...40 Captive Finance Companies Credit Card Issuers Leasing Companies...41 Life Insurance Companies...41 Complementary Financing or Partners to Banks...42 Trade Credit...42 Investors Government Loan Programs, Guarantees, and Grants...42 Industrial Revenue Bonds Participations and Syndications...43 Summary Questions for Discussion Exercise Exercise Chapter 3: Business Legal Structures and Life Cycles...47 Introduction...48 Relationship to the Commercial Lending Decision Tree Legal Structures Types of Legal Structures...49 Sole Proprietorship Business Responsibility and Taxation Business Liability Assumed Name...51 General Partnership...52 Partnership Agreement...52 Business Responsibility and Taxation Business Liability and Activities Limited Partnership...53 Certificate of Limited Partnership...54 Business Taxation and Liability...54 C Corporation...54 Income Taxes for the Owners...54 Business Liability...55 How C Corporations Differ from Other Entities Articles of Incorporation...55 S Corporation...56 Taxation...56 S Corporation Ownership...56 Distribution of Income and Cash...56 Limited Liability Company (LLC)...57 LLC Ownership...57 Limited Liability Partnership iv

3 Lending to an LLC...57 Business Life Cycles What is a Business Life Cycle?...58 General Characteristics of the Life Cycle Stages...58 Matching Products The Start-Up Stage...60 The Growth Stage...61 The Mature Stage...62 The Decline Stage...63 What Are the Key Risk Factors in a Business Life Cycle?...64 Summary Questions for Discussion Exercise Exercise Background Instructions...67 Chapter 4: Introduction to Business Financial Statements Introduction...70 Relationship to the Commercial Lending Decision Tree Financial Statement Analysis Process...71 Role and Purpose of Financial Statement Analysis...71 Financial Statement Analysis Defined...71 Technical and Interpretive Analysis Financial Analysis Overview...72 Step 1: Obtaining Statements Step 2: Processing Statements Step 3: Spreading Statements...74 Step 4: Technical Analysis Step 5: Interpretive Analysis...76 Financial Statement Basics Statement Spreading Guidelines...79 Other Considerations...80 More on Technical And Interpretive Analysis Revisited...81 Limitations of Financial Analysis Quality of Information Accounting Methods...82 External Environment...82 Unlisted Information...83 Distortion in Numbers Aggregate Accounts...83 Basic Analytical Techniques Strengths Weaknesses > Uncertainties Evaluating Statement Quality And Reliability...86 Accounting Standards...86 Internally Prepared Statements...88 Externally Prepared Statements...89 Compiled Statements...89 Compilation Qualifications...92 Reviewed Statements Audited Statements...93 Unqualified Audit Opinion...94 Qualified Audit Opinion...95 Adverse Audit Opinion...96 Going Concern Disclosure...97 Disclaimer of Opinion...99 Management Letter Other Component Analysis Management Plans and Reports Analyzing the Financial Statements v

4 Income Statement Analysis Balance Sheet Analysis Ratio Analysis Cash Flow Analysis Preparing Forecasts Cash Budget Pro Formas Limitations of Analysis Questions for Discussion Exercise Instructions Chapter 5: How Business Financial Statements are Constructed Introduction Relationship to the Commercial Lending Decision Tree Overview of Accounting Methods Cash Method Accrual Method What is Income Tax Basis? Cash Vs. Accrual Basis Practical Example of Cash Vs. Accrual Basis Accounting Refresher Gadgets Etc. First Year on Accrual-Basis Accounting Accounts After Transaction A Accounts After Transaction B Accounts After Transaction C Accounts After Transaction D Accounts After Transaction E Accounts After Transaction F Accounts After Transaction G Accounts After Transaction H Accounts After Transaction I Accounts After Transaction J Accounts After Transaction K Gadgets Etc. Summary Balance Sheet and Income Statement on Accrual-Basis Accounting Gadgets Etc. First Year on Cash-Basis Accounting Accounts After Transaction A Accounts After Transaction B Accounts After Transaction C Accounts After Transaction D Accounts After Transaction E Accounts After Transaction F Accounts After Transaction G Accounts After Transaction H Gadgets Etc. Summary Balance Sheet and Income Statement on Cash-Basis Accounting Comparing Gadgets Etc. Balance Sheets and Income Statements Build Financial Statements Summary Exercise Instructions Widgets, Inc. Accounting Transactions Worksheet Section 2: Analyzing Business Financial Statements and Tax Returns Chapter 6: Income Statement Analysis Introduction Relationship to the Commercial Lending Decision Tree Income Statement Analysis Part 1: Sales and Cost of Goods Sold Analysis The Income Statement Structure and Preliminary Considerations How the Type of Business Affects the Structure Preliminary Considerations vi

5 Types of Businesses Management Objectives Revenue Analysis Net Sales Example Method of Accounting for Revenues and Expenses Sales Volume and Price Trends Sales Mix Order Backlogs Large, Nonrecurring Sales Sales on Extended Terms or to Marginal Customers Cost of Goods Sold Inventory Valuation Changing the Inventory Method Used Reconciling LIFO to FIFO Inventory as a Deferred or Capitalized Cost Inventory Valuation Weighted-Average Cost Method Inventory Valuation Retail Method Gross Profit Gross Margin Trends Income Statement Analysis Part 2: Operating Expense and Net Profit Analysis Operating Expense Analysis Operating Income Operating Leverage Other Income and Expense Analysis Other Income Other Expenses Analysis of Net Profit Before Tax and After Tax Net Profit Before Tax Income Taxes Net Profit After Tax Reconciliation of Net Worth Reconciling Net Worth Retained Earnings Summary Questions for Discussion Exercise Background Dry Supply Case Study Chapter 7: Balance Sheet Analysis Introduction Relationship to the Commercial Lending Decision Tree Business Balance Sheet Considerations Key Considerations Balance Sheet Equation Asset Analysis Current Assets Cash Marketable Securities Accounts Receivable Accounts Receivable: Aged Listings and Concentrations Allowance for Doubtful Accounts Inventory Raw Materials Inventory Work-In-Process Finished Goods Inventory Other Current Assets Noncurrent Assets Fixed Assets vii

6 Fixed-Asset Valuation Depreciation Fixed-Asset Capacity, Efficiency, and Specialization Leasehold Improvements Valuing Fixed Assets Dry Supply s Fixed Assets Other Securities Notes Receivable Due From Officers and Employees, or Loans to Shareholders Due From Affiliates Prepaid Expenses Cash-Value Life Insurance Intangibles Liabilities And Equity Analysis Current Liabilities Overdrafts Notes Payable to Banks Accounts Payable Notes Payable to Others Due To Affiliates or Officers, or Loans From Shareholders Current Maturities of Long-Term Debt Accrued Expenses Other Current Liabilities Noncurrent Liabilities Long-Term Debt Bonds And Debentures Subordinated Debt Reserves Equity (Net Worth) Equity (Net Worth) for Different Business Entities C Corporations Equity Accounts for Other Entities Concept of Tangible Net Worth Summary Exercise Background Instructions Chapter 8: Ratio Analysis Introduction Relationship to the Commercial Lending Decision Tree Ratio Analysis Considerations Ratios and Accounting Methods Income Statement Ratio Characteristics Types of Ratios Liquidity Ratios Current Ratio Quick Ratio Dollar Amount of Working Capital Financial Leverage Ratios Debt-To-Worth or Leverage Ratio Tangible Leverage Ratio Tangible Effective Leverage Ratio Profitability Ratios Return-on-Assets Ratio Return-on-Equity Ratio Efficiency Ratios Accounts Receivable Turnover Inventory Turnover Ratio viii

7 Accounts Payable Turnover Ratio Sales to Total Assets Coverage Ratios Traditional Cash Flow Coverage Interest Coverage Fixed Charge Coverage Dividend Payout Ratio Industry Data Primary Sources of Industry Data Rma s Annual Statement Studies Industry and Trade Associations Trend and Comparative Analysis Trend Analysis Comparative Analysis Summary Questions for Discussion Exercise Exercise Background Dry Supply Case Study Part Part Chapter 9: Cash Flow Analysis Introduction Relationship to the Commercial Lending Decision Tree Overview Of Cash Flow Statements And Reports Why Bankers Focus on Cash Flow Profit Working Capital Cash Flows Sources and Uses of Cash Liabilities and Equity Accounts Asset Accounts Statement of Cash Flows Indirect Method Cash Flow Formats: Indirect Vs. Direct Method Statement of Cash Flows (SCF) Indirect Method UCA Cash Flow Model Direct Method Cash Flows from Operating Activities Indirect Method Cash Flows from Investing Activities Indirect Method Cash Flows from Financing Activities Indirect Method Completed Statement of Cash Flows Indirect Method Statement of Cash Flows (Operating Activities) Direct Method Calculations Using the Direct Method Cash Flow Reports and Other Tools Abbreviated Cash Flow Report Impact of Sales Growth and Other Significant Changes on Cash Flow Summary Question for Discussion Exercise Background Exercise Background Exercise Background Exercise Instructions Part Part ix

8 Chapter 10: The UCA Model Introduction Relationship to the Commercial Lending Decision Tree UCA Cash Flow Model Direct Method UCA Format Compared to SCF UCA Calculations Using the Direct Method Net Cash From Operations (NCAO) UCA Calculations Using the Direct Method Cash After Debt Amortization UCA Calculations Using the Direct Method Financing Surplus (Requirement) UCA Calculations Using the Direct Method Cash After External Financing Advantages of UCA Summary Question for Discussion Exercise Background Exercise Background Exercise Background Exercise Background Exercise Instructions Part Dry Supply UCA Cash Flow Model for 20xy Part Chapter 11: Cash Budgets and Pro Forma Statements Introduction Relationship to the Commercial Lending Decision Tree Analyzing Cash Budgets Cash Budget Overview Inflows and Outflows of Cash, Plus Other Building Blocks of a Cash Budget Use of Cash Budgets Cash Budget Format Example: Cash Budget for a Growing Company (Designs by Dezine, Inc.) Cash Budget Analysis The Role Of A Cash Budget Interrelationship Between the Operating Cycle and Cash Needs Interrelationship Between Working Capital and Capital Expenditures Calculating and Interpreting Pro Forma Financial Statements Considerations for Constructing and Reviewing Projections Projection Assumptions Pro Forma Framework Realistic Assumptions Financial Statement Background Dependability of Performance Time Intervals External Factors Internal Factors Example: Designs by Dezine, Inc Summary of External Factors Summary of Internal Factors Analyzing Pro Forma Statements Past Performance Forecasting an Income Statement Sales Cost of Goods Sold Operating Expenses Operating Profit Other Income and Expense x

9 Income Taxes Forecasting the Balance Sheet Assets Liabilities and Net Worth The Plug Accounts Analyzing Each Scenario Uncertainties in Forecasts Summary Exercise Instructions Part Part Exercise Instructions Exercise Instructions Section 3: Analyzing Personal Financial Statements and Tax Returns Chapter 12: Types of Personal Financial Statements Introduction Relationship to the Commercial Lending Decision Tree Personal Financial Statement Overview Basic Formats Sample Format and Preliminary Analysis Personal Financial Statement Components Personal Information Income & Expenditure Statement Income Analysis Expenditures Analysis Balance Sheet Asset Analysis Liability Analysis Net Worth Contingent Liabilities Other Information Requested Representations and Warranties Summary Questions for Discussion Exercise Instructions Chapter 13: Key Ratios and Adjusted Net Worth Introduction Relationship to the Commercial Lending Decision Tree Key Ratios From Personal Financial Statements Sample PFS Format Liquidity Ratio Unsecured Debt Ratio Debt-To-Income Ratio Adjusted Net Worth Components of Adjusted Net Worth Outside Net Worth Calculating Adjusted Net Worth Summary Questions for Discussion Exercise Background Instructions Exercise Instructions Exercise xi

10 Instructions Chapter 14: Personal Tax Returns and Cash Flow Introduction Relationship to the Commercial Lending Decision Tree Introduction to Personal Tax Returns Key Uses of Personal Tax Returns and Common Forms Income Vs. Cash Personal Tax Return Components Initial Review Analysis of Income and Form Related Analysis of Income and Form 1120S (S Corporation) Personal Cash Flow Analysis Calculating Personal Cash Flow Key Sections and Calculations Summary Question for Discussion Appendix A: Dezine Personal Tax Return Chapter 15: Combining Business and Personal Cash Flow Into Global Cash Flow Introduction Relationship to the Commercial Lending Decision Tree Global Cash Flow Overview Why is Global Cash Flow Needed? Two Analytical Issues No Single Correct Method for GCF Global Cash Flow Example Calculating Global Cash Flow Summary Question for Discussion Exercise Instructions Appendix A: Personal Cash Flow Glossary Terms Index xii