Tips For Analyzing Tax Returns and Personal Financial Statements

(1) Tax Returns Form 1040
Most lenders require the business principal (s) to provide most current three-year personal and business returns. The returns are subjected to thorough analysis to determine creditworthiness of the borrower (s) and the owners. Here are just a few of the silent points to note:

• Look at the top left corner of the return to find the form number and description. For example, Form 1040 U.S. Individual Tax Return.
• Verify year, owner, filing status (singly or jointly) and if signed
• Ensure all schedules are attached including Schedule K-1 (K-1 is not part of Personal Return)
• Must have Schedule K-1 for any entity listed on Schedule E
• Verify income by cross checking with W-2s and Business tax returns, if business and real estate income is reported
• Verify ownership of assets and test reasonableness of values
• Check if sources of income match assets
• Adjusted Gross Income (AGI) is not actual income or cash received
• Individual tax return is usually prepared using cash basis except for depreciation
• Income from sale of assets is net of depreciation and selling expenses
• Some types of income are deferred
• Income reported must therefore be adjusted to cash to determine funds available for debt service
• Income from sole proprietorship or partnerships is excluded from cash flow
• Some non cash items can be included, e.g. certain insurance benefits, personal use of company vehicle and stock options
• There is little or no correlation between income reported on Individual Income Tax Return #1040 and cash
• Schedule K is a very important part of the puzzle. It records contributions, distributions and repayment of debts to owners.
• The credit analyst ignores the tax deductible portion of the loss from rental properties or investments shown on Form 8582and instead considers cash flow of the properties as shown in Schedule E or K-1.
• An analyst should be interested in the amount of tax owed, not the minimum tax calculation
• Borrower's share of Interest paid to partnerships and corporations should be excluded from cash flow
• Determine actual cash received from capital gains and whether they are recurring
• Distinguish between taxable portion and rollovers of IRA Distributions
(2) Personal Financial Statement (PFS)
This is a summary of personal assets and liabilities and income/expenses that provide information on income and assets that may be pledged as collateral. Often, the statement will not differentiate the assets and liabilities of the owner from that of the business.
An ideal Personal Financial Statement should be;
• addressed to your bank, preferably in your bank's format
• dated prior to the loan and signed by the borrower and his/her spouse if assets are owned jointly or if they are co borrowers. The signature(s) affirms that the statement is true and correct; it is presented for the purpose of obtaining credit and that the borrower will notify the bank of any material change on the borrower's financial condition.
• current, preferably not more than 90 days old or is inconsistent with the loan policy
• accurate with no arithmetical errors and assets and liabilities must balance
• supported by schedules of assets and liabilities, insurance policies, cash deposits, investments, unused lines of credit, loan balances, terms, lenders, contingent liabilities etc
• obtained at least once a year together with business financial statements and tax returns
• reviewed with borrower for completeness; to understand the reporting method and supporting documentation
• tested for marketability of assets, solvency, liquidity, debt/equity, verifiability and continuity of income and expenses.
• adjusted to exclude value of assets that have no value to the bank, those that cannot be easily liquidated or co-owned assets, personal assets, non-marketable securities, pledged CVLI (Cash Value Life Insurance), accounts receivable, closely held companies and pledged assets
• subjected to a verification process of asset ownership, asset values and liabilities. Use tax returns, credit report, searches and published comparable sales.

Franc Jo has worked as a banker for over 20 years and has owned small businesses. Currently, he is the senior underwriter with and author of many articles relating to loan matters.

In his many years as a commercial lender he reviewed thousands of business plans, financial statements, cash flow projections, and other borrower information. Over the years he acquired valuable experience in all types of lending, credit review, credit analysis, credit underwriting and impaired asset management. And as an entrepreneur he learned firsthand how to start businesses from scratch and grow them to successful enterprises.


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