Are you a lender who's ever been stumped by a borrower's financial statement? You're not alone. Financial statement analysis can be a tricky task, especially when you are looking to scale your business. But fear not. We're here to help! In this comprehensive guide, we'll take you through the steps to easily analyse your borrowers’ financial statements.

We'll dive deep into a simple process for analysing bank statements, making it easier to identify red flags, understand a borrower's financial situation, and ultimately make informed lending decisions. So, let's get started.

What is Financial Statement Analysis?

As a lender, it's crucial to understand a borrower's financial situation before approving a loan. This is where financial statement analysis comes into play. In simple terms, financial statement analysis is the process of examining a borrower's financial statements to assess their financial health and determine their creditworthiness.

Financial statements include information about a borrower's assets, liabilities, income, and expenses. By analysing these statements using various financial ratios and metrics, lenders can better understand the borrower's liquidity and financial stability. A thorough financial statement analysis can also help lenders identify potential red flags, such as high debt-to-income ratios, negative cash flows, or inconsistent income streams.

Why is Accurate Financial Statement Analysis Crucial for Lending Businesses?

Imagine you're a lending business, and a potential borrower asks for a loan. They seem trustworthy and provide a stack of financial documents. At that point, after analysing the documents, you decide to approve the loan. Later, you find out that the borrower had misrepresented their financial situation and is now defaulting on the loan. Not only have you lost the money, but your business's reputation has been hit.

This is why accurate financial statement analysis is important for lending businesses. Here are a few more reasons:

1. Assess borrower’s ability to repay: It helps to evaluate the borrower's creditworthiness by determining their ability to repay the loan based on their financial position, income, and expenses. Hence, the lender can decide whether or not a loan should be approved.

2. Calculate the risk and act accordingly: Financial statements also provide insights into the borrower's financial history, including their debt-to-income ratio, payment history, and credit score, which help the lender determine the level of risk associated with lending to the borrower.

3. Identify and eliminate frauds: Financial statements help lenders identify any red flags or warning signs that could indicate potential default or fraud, such as inconsistencies in the borrower's financial statements or excessive debt.

4. Make informed decisions and implement risk-based pricing: With accurate financial statement analysis, lenders can make informed decisions about the loan amount, risk-based pricing on the interest rate, and repayment terms based on the borrower's financial situation.

5. Stay compliant as lenders: It helps lenders comply with regulatory requirements, such as anti-money laundering laws and Know Your Customer regulations, by verifying the borrower's identity and source of income.

In a study conducted by McKinsey & Co , it was found that banks that effectively analyse financial statements can reduce credit losses by up to 30%.

Understanding Bank Statements

As a lender, it's crucial to understand that bank statements can provide valuable insights into the borrower's spending habits, income, and financial obligations. 

Lenders should look for consistency in the borrower's income and spending patterns and any large withdrawals or deposits. This can help lenders identify any potential red flags or irregularities indicating financial instability or possible fraud. Additionally, lenders should be aware of recurring payments or debts, such as credit card bills or loan payments, that may impact the borrower's ability to repay the loan.

Lenders must closely evaluate numerous elements from a borrower’s bank statement with the same objective. Here are some of the most important ones:

• Deposits : The frequency and consistency of deposits in the borrower's bank account determines the borrower's primary source of income and whether it's stable and reliable.

• Withdrawals : Lenders should also analyse the frequency and amounts of withdrawals from the borrower's bank account. Large withdrawals could indicate financial instability or an unexpected expense.

• Bank fees : Bank fees can impact a borrower's overall financial health. Lenders should look for excessive bank fees, such as overdraft fees, which could indicate financial stress.

• Recurring payments : Recurring payments, such as rent or mortgage payments, should be examined properly, and compared to the borrower's income. This can help determine if the borrower can afford their monthly obligations.

• Account balances : Lenders should review the borrower's account balances over time. Consistent positive balances could indicate financial stability, while negative balances could indicate financial stress.

• Transactions with third parties : All transactions with third parties must also be examined to ensure that they match the borrower’s claimed expenses.

How to Streamline the Lending Process with Financial Statement Analysis?

Once you have a copy of the applicant’s bank statements for the last 3-6 months, follow these steps to analyse the bank statements and decide upon the applicant’s eligibility for a loan:

1. Assess cash balance in applicant’s account

When evaluating a loan application, the first factor that you must consider is the balance in the applicant's bank account. A positive cash balance indicates that the borrower has available funds and can manage their cash flow effectively. This increases the likelihood that the borrower will be able to repay the loan in the future, making them a more desirable candidate for lending.

On the other hand, a negative cash balance reflects poor financial management by the applicant and raises concerns about their ability to repay the loan. Most lenders may view such applicants unfavourably and may be less likely to approve their loan applications.

The ideal cash balance a borrower should maintain in their bank account depends on the loan amount they are applying for. Generally, the larger the loan application amount, the higher the balance they should maintain. 

2. Track down the deposits

When assessing a loan applicant's eligibility, it's crucial to analyse the deposits in their bank account. Regular deposits indicate a steady source of income, which is an essential factor in determining the borrower's ability to repay the loan on time. Therefore, it's important to identify the sources of regular deposits in the bank statement.

For example, if a loan applicant is a salaried employee, regular deposits from their employer indicate a steady income source that increases the likelihood of loan approval. In the case of a business loan applicant, regular deposits from customers or clients suggest that the business has a stable cash flow and is profitable.

A significant point of caution is if the last deposit was made months ago. This may indicate an unsustainable income source, which raises concerns about the borrower's ability to repay the loan. Similarly, irregular or large deposits may also raise suspicions. In such cases, you must ask for an explanation about the origin of the funds and demand justifications to ensure that the source of income is legitimate and sustainable.

For instance, if a loan applicant has large irregular deposits, you can ask for documentation showing the source of the funds, such as invoices or receipts. If the borrower cannot provide a satisfactory explanation, the loan application may be denied.

3. Closely examine the withdrawals and liabilities

One crucial aspect to consider is the withdrawals made from the account, especially any significant or frequent withdrawals. For instance, a borrower with regular withdrawals of the same amount might suggest that they have undisclosed debts or loans they are paying off.

Moreover, you should take into account any liabilities that the borrower has. While some liabilities, such as office expenses, may be necessary to run a business, others may signal potential financial difficulties. Ask borrowers about any undisclosed liabilities that might impact their ability to repay a loan.

To get a realistic view of a business loan applicant's financial standing, you should deduct business liabilities from their average monthly profit. Borrowers with regular withdrawals and liability payments but with figures still less than regular deposits are ideal candidates for business loans as they demonstrate the capacity to repay the loan.

For example, suppose a borrower has regular withdrawals for office expenses and lease payments. In that case, you can positively factor these recurring expenses into their assessment, provided that the borrower's income supports their ability to repay the loan after deducting these costs.

4. Analyse Cash Overdrafts

A cash overdraft occurs when a borrower withdraws more money than is available in their account, using a bank's overdraft facility to access additional funds.

By examining a borrower's bank statement and identifying any instances of overdrafts, you can gain insight into the borrower's financial management skills. Overdrafts are typically viewed as a red flag, suggesting that the borrower may struggle to manage their finances effectively and have difficulty repaying the loan.

For example, if a borrower has a history of frequent overdrafts on their bank statements, this may indicate that they have a habit of spending beyond their means and may be at a higher risk of defaulting on a loan. Conversely, suppose a borrower has no history of overdrafts and consistently maintains a positive balance in their account, it may indicate that they are financially responsible and more likely to repay the loan promptly.

Trends and Patterns to Identify in Transaction History 

Every bank statement shows a certain trend and pattern. From recurring transactions to spending habits, frequency of deposits, and more – each pattern tells you a story. As a lender, it’s vital to identify such trends and patterns so as to make more informed decisions about whether or not to approve a loan.

Some examples of such trends and patterns include:

• Regular payments to a savings or investment account indicate that the borrower is financially responsible and saving for the future

• Frequent overdrafts or bounced cheques indicate that the borrower may have difficulty managing their finances.

• Large purchases or withdrawals made at bars or casinos suggest that the borrower may have a gambling problem or live beyond their means

• Regular payments to credit card companies suggest that the borrower may have a high level of debt and may struggle to make payments on time

By identifying these trends and patterns, lenders can make more informed decisions about whether or not to approve a loan. It's important to remember that each borrower is unique and that trends and patterns should always be considered in the context of the borrower's overall financial situation.

Key Considerations While Interpreting Financial Statements for Lending

As a lender, there are some important considerations you must keep in mind when interpreting the bank statements of your potential borrowers:

1. Verify the authenticity of the statement : Make sure the statement is an original copy and not a forged document.

2. Check for inconsistencies : Look for any inconsistencies in the statement, such as missing pages, altered transactions, or discrepancies in balances.

3. Look at the source of income : Identify the primary sources of income and the frequency of deposits and ensure they are consistent with the borrower's stated income.

4. Evaluate credit card transactions : Review credit card transactions to identify any high balances or late payments which could indicate financial distress.

5. Timing of transactions : Pay attention to the timing of transactions, such as large deposits or withdrawals, around the time of loan applications. This can help identify any attempts to inflate income or hide liabilities.

Although analysing borrowers’ transaction history forms a great starting point to make calculated lending decisions, lenders should also be aware of the limitations of financial statements. It’s vital to take into account a statement’s historical nature, biasness, limited scope of analysis, the potential for easy manipulation, and possibility of incomplete information.

Scale Your Lending Business Seamlessly with Automated Bank Statement Analysis

Financial statement analysis is the most crucial task of lenders as it provides insight into the financial behaviour of potential borrowers. By reviewing bank statements, lenders can assess a borrower's creditworthiness, determine their ability to make regular loan payments and identify any potential risks. This information is crucial in making informed lending decisions and minimising the risk of defaults and loan losses.

However, manual financial statement analysis can be overwhelming when you aim to optimise and scale up your lending business as you may run out of time and resources. BankConnect by FinBox helps you automate the heavy work of analysing financial statements, enabling you to process loan applications faster, reduce the risk of human error, and improve overall operational efficiency. 

Additionally, FinBox DeviceConnect can provide deeper insights into borrower behaviour and trends, allowing you to better tailor loan products to specific market segments. The underwriting platform enables you to assess even thin-file borrowers without a formal credit history.

As a result, you can seamlessly scale your lending business by reaching more customers and increasing loan volume while reducing costs and minimising risk.