The CPA Journal

By Neville Grusd

Projections form a basic part of a lender’s credit package, both for initial approvals and in the monitoring of the account. A well-prepared projection helps one understand a company’s business, seasonal fluctuations, and how these affect the credit line and collateral availability. At a joint panel discussion late last year of the NYSSCPA and the New York Chapter of the Commercial Finance Association (CFA), lenders and accountants discussed various aspects of the preparation, presentation, and use of projections by lenders. The lively discussion that followed indicated that this was a subject of interest to both groups.

Good managers automatically prepare projections for the planning and control of their business. It is a necessary tool that enables planning, monitoring of performance, and increased efficiency. By regularly comparing actual results with projected results, corrective action can be taken on the variances. From the lender’s point of view, a projection is a vital tool in keeping track of how a company is performing. If the account officer is checking the vital signs against the projection on an ongoing basis, any material variations will call for discussion and enable action to be taken before a crisis occurs.

Sufficient information is necessary in the projection for a lender to make a decision on whether to grant credit or not, and to see whether the proposed credit line and collateral formula fits the borrower’s needs and the lender’s parameters. Experienced managers and accountants should know what to present.

Period. Long-term strategy does not help the asset-based lender evaluate the client’s short-term requirements. Generally what is needed is a one-year projection, broken down monthly.

Basis of preparation. Projections should be prepared on a realistic basis. Where there are critical periods of the year, where an increase or decrease in volume or other major components of the projection may have a material impact on borrowing needs or availability, then supplementary calculations should be made. These would show what would happen in certain months if, for example, volume was 10% up or down.

Format. The projection should show monthly income statement, cash flow, balance sheet, and availability (i.e., collateral compared with total borrowing requirements). If the projection is being given to an existing lender, the calculation for availability should be based on the current formula, making reasonable allowance for ineligible components of assets included in the formula. If the projection is for prospective lenders, reasonable advance rates should be used. Where letters of credit are required, a separate section showing the monthly flow of letters of credit should also be given.

The quality of projections presented to lenders varies greatly, depending upon management and the accountants preparing them. The following are some practical items that lenders should look for.

Assumptions. Every projection should be accompanied by a clear statement of the major assumptions on which it is based, and should be reviewed for reasonableness. Major items such as sales volumes, gross-profit percentages, and accounts receivable turn should be compared with results in prior years. If there are material differences, these should be justified by the borrower. Lenders should insist that assumptions be submitted. An important backup to the sales projection is orders on hand. A schedule of these should be submitted with the projection.

Balance sheets. It is vital that balance sheets be included. First, one should make sure that the opening balance sheet is correct or reasonable. If this is not the case, then everything that follows is inaccurate. The opening projected balance sheet should make sense compared with the latest interim numbers available, or with the actual year-end statement, if available. Second, the balance sheets ensure that all the assets and liabilities of the company are taken into consideration when preparing the cash flow. A projection has to be changed if a balance sheet is prepared and then it is realized that some items have been left out of the cash flow. Finally, the monthly balance sheets will show whether the client is in compliance with the net worth covenant at all times.

Seasonal fluctuations. Because of possible fluctuations from month to month, the lender should question whether the gross-profit percentage was properly applied each month, and whether adequate provision was made for dilution. Monthly overhead should also be reviewed to ensure that if there are fixed and variable components of the expenses, this factor was properly taken into account.

Intra-month peaks. A major shortcoming of the monthly projection format is the impact of intra-month peaks. Where sales occur heavily at the month-end but expenses must be paid earlier or evenly during the month, such a projection reflects only the month-end position, the most favorable one for the lender. Problems will be avoided if intra-month peak calculations are presented and any potential shortfalls in collateral at those times are addressed in advance, not at a crisis point.

Mathematical accuracy. Most projections are prepared by computers that make excellent presentations, but the user would be well advised to check the mathematical accuracy of the calculations. Simple tests that could be applied to the data include calculating whether the gross profit ties in with the assumed percentage. Also, by applying the projected accounts receivable turnover, it is simple to calculate whether the outstanding accounts receivable at the end of the year is an accurate number.

Projections (sometimes forecasts) submitted by an outside accountant should lend additional credibility to the borrower’s presentation. Usually the projections are “compiled,” and the CPA report will state that they were prepared in accordance with standards established by the AICPA. The representation of management does not include evaluation of the support for the assumptions underlying the forecast. These assumptions are not examined, and therefore the CPA cannot express an opinion on them or any other form of assurance on the statements or assumptions. They may differ from actual results, because events and circumstances frequently do not occur as expected. In spite of the foregoing disclaimers, CPAs do have some responsibility for the projections, particularly if they know that material facts or circumstances are not disclosed. There is no “review” report for projections from CPAs. While it is comforting for the lender to receive a projection from the client’s outside CPA, it is still the lender’s responsibility to review both the assumptions and the computations.

Experienced lenders can sense whether the projection is reasonable or not. Red flags are unusually high revenues, gross profits, and net incomes when they have never existed before. Projections that sound too good to be true usually are.

If the numbers make sense and the projection shows the borrower can operate within the credit line and lending formula at all times, it forms a solid basis for continuing and monitoring performance. If there are periods where the projection shows the borrower over the line or out of formula, these issues must be addressed in advance. The borrower may have to find the means of reducing the amount of the borrowings by obtaining additional credit terms from suppliers, investing more capital, or providing outside collateral. The major advantage of working with projections is that variations from plan and potential problems are discussed before they occur.

A projection must be considered a dynamic document. It should be reviewed quarterly, or when there is a major change in an underlying assumption, and revised and updated as circumstances change.

Neville Grusd, CPA, is executive vice president of Merchant Financial Corp. and Merchant Factors Corporation in New York City and a member of the NYSSCPA’s Board of Directors and Executive Committee.

This article was adapted from “Projections: A Practical Approach to Preparation, Presentation, and Use by Lenders” in the September/October 2001 Secured Lender. Readers with suggestions or comments are encouraged to contact the CFA Committee for Cooperation with Accountants at (212) 594-3490 or postmaster @cfa.com.