Banking, Lending and the secret code found in your financial statements

All of us have a financial statement, whether you are an individual, household or business. Knowing what your financial statement might be secretly communicating to creditors and lenders may mean the difference of getting a loan, mortgage, equipment financing or working line of credit you so desperately need. But the true magic is knowing how to use these secret codes to better manage your financial position and grow your net wealth.

As a CFO and CPA, I spend a lot of time working with clients to help them understand what their financial statements are communicating and how to use this information to improve their financial position. Typically, new clients come to me bewildered as to why they can’t seem to get qualified for that mortgage or business financing that they need or have no clue that their financial statements are secretly having a conversation with their lenders without them. So if you feel like this, find comfort that you are not alone. A vast majority of people have never been shown how to interpret the secret messages buried within their financial statements.

Let’s start with the basics. What are financial statements? Basically, they are a snapshot of everything you own, everything you owe, all the income you make, the expenses you pay and how you utilize what is left over at the end of the day. They consist of three standard statements:

1. Balance Sheet – shows everything you own and everyone you owe money to and whatever the difference between the two is your net wealth.
2. Income Statement – shows everything you make, all the expenses you pay and whatever the difference between the two is you net income.
3. Cash Flow – shows how you used whatever was left from your income statement (your net income) to increase what you own or pay down what you owe (your net wealth).

Within all these numbers are some very simple but important relationships. Understanding these relationships will help you better understand where you are at financially and will give you crystal clear insight into how lenders and creditors see you through their narrow lens of perception and what to focus on to improve your financial position.

Below is a sampling of the most common ratios I look at as a CFO and CPA when I am reading clients financial statements:

While understanding some of these ratios and how to deploy them in a meaningful way takes years of financial education and modeling experience to do, others are more simple and are able to be quickly deployed in your arsenal of financial tools. Those are the ones that are secretly communicating to your lenders without your knowledge.

Before we get too far into how to calculate and interpret these ratios, I think it is best to define some terminology first.

Liquidity – looks at the amount of cash you would have (or the amount of cash you would need) if you were to have to liquidate all of your short-term resources and pay off all your short term debts. Short-term usually means within 30 to 90 days. These ratios are important because they tell creditors that should something happen like you lose your job or lose a large customer and your income were to significantly change overnight, how well you will be able to pay all your immediate debt and bills (including them).

Leverage – looks at how much of your portfolio is financed through debt versus how much is from personal investments and sweat equity. This ratio varies greatly amongst different industries and is a bit more challenging to calculate and interpret. But there are a few ratios that can be applied across all industries and individuals uniformly and tell creditors a lot about how well you will be able to make payments to them and still have enough resources left to pay everyone else and survive.

Profitability – the misnomer here is that this in only for businesses. This can be used for both business and personal portfolios and is a measurement of how well you convert income into cash. A good example on the personal side is your taxes. Say you make an annual income of $100K, how much of that salary is eaten up by paying taxes and how much is used up in household expenses? Understanding these ratios and having the right strategies in place can make a significant difference in how much of the $100K you actually get to keep in your pocket.

Activity – while some of these ratios are specifically for businesses or specific industries, others can be applied across both business and personal financial statements and across all industries. These ratios help you understand the key drivers of your cash flow and help you monitor your investments in key performance indicators such as employees, inventory, and customers.

So now that we have a basic understanding of the terminology of ratios and financial statements, let’s look at some of the most commonly used ratios when it comes to financing and creditors (which are indicated with an * in the above list).

As you may have noticed, many of these ratios measure your levels of liquidity, leverage and profitability and how it all boils down to being able to make your monthly debt payments over time. While you can not necessarily see these relationships simply by looking through your financial statements, with a little bit of simple math, you can glean a lot about how financially healthy you are. Furthermore, your financial statements are having this exact conversation with your creditors without any input from you as to who you are and how financially trustworthy you are. Taking the time to understand what it is these ratios are saying and how to manage them is a very important step in managing your financial health and growing your net wealth.