What do you need to consider when relying upon income statement projections for a loan approval?
A lender engaged Abacus Credit Analytics to underwrite a loan for a new children’s therapeutic gymnasium. (We had to educate ourselves as to what exactly a therapeutic gymnasium was- link.) We were immediately curious about the top line revenues and total operating expenses reflected in the income statement projections. The Borrower was a start-up entity with no historical financial statements.
Revenue Projections:
The income statement projections depicted a slow build-up in revenues as operations stabilized. Each owner was an experienced early-childhood educator. However, neither owner had run a business. When we asked about the slow build-up in revenues, the owners noted their lack of business experience. The Borrower explained that they were actively working to build a referral network of physicians, physical therapists and medical practitioners. But, they were being prudent in building the referral network. The owners wanted to ensure the referral sources shared their outlook on the benefits of therapeutic play. They did not want every medical professional in their network- they wanted the right medical professionals in their network. The resultant income statement projections were conservative and reflected a measured approach towards stabilization.
What was the impact on the income statement projections?
We were able to sensitize the projections based upon the methodology the Borrower used to create their projections. This allowed us to evaluate potential conservative and break-even cash flow scenarios. This analysis allowed the Lender to understand the downside risk to an acceptable DSCR. Additionally, the loan officer was able to plot actual monthly revenues against the various income statement scenario forecasts during the stabilization period for the children’s gymnasium. The loan officer was given a tool to spot cash flow issues long before an annual statement was compiled for this Borrower.
Operating Expense Projections:
When Abacus reviewed the projected operating expenses we concluded they were reasonable and appeared to be inclusive except for one critical line item. The income statement projections did not include officer salaries. How could the owners live with no salary?
What was the impact on the income statement projections?
While it is not customary to exclude officer salaries from forecasted expenses, we determined in this instance that this was acceptable. We concluded that the income of each spouse supported personal debt service and estimated living expenses. Each spouse had a very stable employment history with no gaps in employment in the prior 15 years. Due to the outside cash flow generated by each spouse, the lack of officer salaries in the projections was deemed reasonable.
Wrapping Up:
The outcome for this Borrower was favorable. Abacus recommended this loan for approval. Despite having no experience as business owners, the Borrower had demonstrated that they understood their financial statements. They did not set out with a specific net income or net loss in mind- they let their business plan drive the numbers, not the other way around. Reasonable facts supported the financial projections. The basis for critical assumptions was well-supported. In general, it was clear that the owners had done sufficient research. It was obvious from the quality of information that each owner had fully committed to this project.