Pick the Wrong Bank

What do bankers and lemmings have in common? OK – that’s too easy. The technical term that economists use for bankers is pro-cyclical. That means bankers exacerbate booms by lending too much in good times, and make recessions deeper by tightening credit in bad times. Of course, that is not the total fault of bankers. Bank regulators push lending underwriters into pro-cyclical policies. When the regulators screw up and lots of loans go bad, they enforce tighter lending standards that restrict credit at exactly the time the economy needs loose credit.


Bankers are like also lemmings in that they don’t act in their own best interests. Bankers figuratively walk off cliffs blindly following their instincts as lemmings do. Like lemmings, most of the bankers I know don’t have great instincts or judgment. Prior to becoming loan officers, I suspect many worked as waiters or clerks at J.C. Penney. The guy who was trying to sell you a cheap suit last year may be championing your loan application before a bank underwriting committee. I’ll bet that gives you a warm feeling. While I am bashing bankers, in fairness, I should note that you can find good bankers. You just won’t find many, if any, in the large national banks. You have to look at local banks specializing in small business lending.

Let’s dig a little deeper into why a suit salesman will make a bad loan officer for you. This is how the loan application process works at large banks. First your loan officer, the former suit salesman, gets you to put together a loan package. The package likely includes business and personal financial statements as well as business and personal income tax returns. There is nothing wrong with the package itself. The problem is what happens with the package.

Unfortunately your loan officer will then look at the package. What is wrong with that? He / she likely understands only one number in the package – the bottom line from your profit and loss statement. Why is that bad? Your profit and loss statement shows if you are making a profit or are losing money. Why shouldn’t a banker rely on that information? For just about every small business, the amount of profit or loss in the financial statements can charitably be described as massaged. They could not so charitably be described as misleading. Smart guys like me are busy trying to get the profit number down to the smallest number possible for tax purposes in a lot of situations. Other smart guys like me are trying to find a way to show the largest profit possible. The profit number is only a small start in understanding the financial position of a business.

Here is an example how two identical companies can report entirely different results. First, let’s assume each company has revenue of $1,000 and operating expenses of $600 before the owner’s compensation. Company one is what is known as a C corporation and company two is an S corporation. What is the difference between C and S corporations? Well a lot, but this isn’t a tax course. I will just leave it as follows. C corporations pay tax twice on profits. They pay once on the company’s annual tax return and then again if the company pays the profits out as dividends to the owner. An S corporation pays just one level of tax. When some smart CPA is looking at company one’s tax situation at the end of the year (we know he / she is a smart CPA, since he is doing tax planning during the year for the company), he / she knows the company is about to face double taxation on $400 of profits. The CPA will recommend paying the owner a year-end bonus that is deductible from taxable income. That shields the bonus amount from double taxation. Let’s assume the bonus will be $300. That leaves $100 as the profit for the business.

Let’s now look at company two, the S corporation. The CPA will look at the same $400 of profit and, since this profit will only face one level of taxation whether there is a bonus or not, recommend that no bonus be paid. Therefore, the profit remains $400. As you can see, we have two companies with the same cash flow and operating results that are showing two vastly different profit numbers. Most bankers will not look favorably at company one’s loan application, but very favorably at company two’s application.

What happens next in the loan application process? The loan officer, or worse the assistant suit salesman, will enter the business and personal financial information into the bank’s credit scoring software. Above, I casually mentioned that most bankers really don’t understand financial statements except for the profit number, and as we saw above, they really don’t understand that number either. Now that same banker (or the assistant, who knows even less) will try to take the amounts from your company’s balance sheet and income statement and enter them into the computerized scoring program.

Once I got a call from a banker, who was trying to enter financial statements from one of my clients into the scoring system. He told me the balance sheet I had prepared didn’t balance. Of course, you could look at the balance sheet I had prepared and see very easily it DID balance. I even re-added the amounts while on the telephone with him to make absolutely certain. I then asked him to add the numbers on his adding machine outside the computer program. He did. The assets really did equal the liabilities plus owner’s equity, the basic accounting equation for a balance sheet. Now he had me perplexed. This was how I learned about the computer scoring program he was using. It wasn’t that my balance sheet didn’t balance. It obviously did. The problem was that he couldn’t get the balance sheet correctly entered into the program.

In his defense, the equity section of the balance sheet had a somewhat unusual line item called treasury stock. Treasury stock arises when a company buys back its own stock. This typically happens when the company’s money is used to buy out an owner. Treasury stock is a reduction in equity and appears as a negative number in the equity section of the balance sheet. My client’s banker was trying to enter treasury stock as a positive instead of negative number. In fact, it was worse than that. When I told him to enter the amount as a negative number, the computer scoring program rejected the entry. I justifiably blame him for not understanding the treasury stock concept he probably first encountered in accounting 101 back in his freshman year of college. I also blame the bank for an incredibly poorly written program. I can’t imagine this large national bank had never dealt with treasury stock before. How did a resourceful guy, like me, get around the problem? I had the banker subtract the treasury stock from retained earnings, another fortunately positive number in the equity section of the balance sheet. Problem solved!

Let’s assume the banker successfully enters all the financial statement amounts into the credit scoring program. What happens next? The numbers are analyzed by the bank’s credit scoring system, which resembles the machine from the Wizard of Oz. Why does it resemble the machine from the Wizard of Oz? There is very little substance behind the computer curtain. When you analyze misleading numbers, what do you get? You get a misleading analysis. Based on this analysis, the loan application receives a numerical score based on a fancy algorithm. Here is a financial principle for you. It will put you ahead of most bankers. When you analyze misleading numbers, you come to a misleading conclusion regardless of how much rocket science you apply. For small businesses loan applications, there are two predictable results. The loan is denied or the owner is offered a home equity line of credit. Neither is the result the owner wanted.

How does a small business owner avoid the mess above? Go to a small business bank. Your CPA should have personal relationships with several. Why are small business banks different? They are different in that real bankers can sometimes be found in small banks. If you are lucky, you will find a banker who can read financial statements and place the proper degree of reliance on them. He / she should be smart enough to determine real cash flow outside of one-time items like bonuses. If your CPA doesn’t know any such bankers, call me. I know several.