When you want to assess an individual's or a business's financial situation, the first key document that comes to mind is financial statements. It’s the beginning point for all the lending activities to find out if a borrower will fulfill their debt obligation in a timely fashion. 

But did you know that even financial statements have numerous limitations when it comes to evaluating creditworthiness? In fact, even after a thorough analysis, a creditor might end up putting their capital at risk.   

No doubt financial statements provide a snapshot of a borrower’s financial performance and position for a specific duration of time. They can help lenders assess the borrower’s creditworthiness, liquidity, and profitability, among other factors. 

However, they should be viewed in conjunction with other sources of information, such as industry trends, market conditions, overall business metrics, and the business model itself.

In this blog, we will discuss the most crucial limitations of financial statements which lenders must account for while evaluating borrowers.

What are Financial Statements?

Financial statements are essential documents that provide a summary of an individual’s financial activities. They are typically composed of four primary elements: the balance sheet, income statement, cash flow statement, and statement of changes in equity.

• The balance sheet provides a birds-eye view of the borrower’s financial position at a specific point in time by presenting its assets, liabilities, and equity

• The income statement , on the other hand, provides a summary of the person’s income and expenses over a specific period, indicating net assets

• All the cash inflows and outflows are covered in the cash flow statement

• The statement of changes in equity shows how equity has changed over time

It’s evident that financial statements play a crucial role in facilitating transparency, accountability, and informed decision-making. Let’s now take a deep dive into the 

Why are Financial Statements Vital for Lending Decisions?

Financial statements play a crucial role in lending as they provide a comprehensive picture of a debtor’s financial health.

Here are the top reasons why financial statements are analyzed first while making lending decisions: 

1. Evaluate the borrower's creditworthiness : Financial statements provide an overview of a borrower's financial situation, including assets, liabilities, and cash flow. Lenders use these statements to determine the borrower's ability to pay back a loan. For example, a bank may look at a borrower's income statement to determine if the borrower generates sufficient cash flow to make timely payments.

2. Identify potential risks : These documents also help lenders identify potential risks associated with lending money to a borrower. By analysing the balance sheet, lenders can evaluate a borrower's solvency and liquidity. This information enables them to identify any risks of default or bankruptcy. A lender may also use a borrower's income statement to determine if the borrower has a history of financial stability.

3. Monitor loan repayments : Financial statements provide a basis for monitoring a borrower's repayment performance. Lenders can use the information in financial statements to compare actual repayment with scheduled payments. This information helps lenders identify early warning signals of potential default or delinquency.

4. Comply with regulatory requirements : Another vital reason is regulatory requirements for banks and other financial institutions. Financial statements enable banks to comply with these regulations by providing data on their financial health.

According to a survey by the Federal Reserve, 92% of banks consider financial statements to be essential for assessing a borrower's creditworthiness. However, let’s now look at their limitations.

Limitations of Financial Statements

As a lender, it is important to supplement financial statements with additional financial information to make informed lending decisions. By doing so, lenders can more accurately assess a borrower's financial position and make lending decisions that align with their risk tolerance and business objectives.  Here’s why:

#1 Financial statements provide a historical view

Financial statements provide a historical view of a borrower's financial performance, which can be useful in assessing their track record. However, relying solely on historical information may not give a complete picture of a borrower's current financial position. 

For example, a borrower may have experienced a sudden increase in revenue in the past year, but this may not be reflected in their financial statements. Additionally, the valuations of their assets and debts may vary extensively over the period. 

As a lender, it is important to supplement historical information with up-to-date financial information to accurately assess a borrower's financial position.

#2 Financial statements are based on personal assumptions (Biasness)

Financial statements can sometimes rely on the judgments and assumptions made by the borrower's management team. These personal assumptions may be biased and can affect the accuracy of the financial statements. 

For example, a small business owner and their accounting team may have a positive outlook on the business’s future prospects and may overestimate future earnings potential. As a lender, you need to ensure the high credibility and reliability of the borrower's business model when assessing the accuracy of their financial statements.

#3 The scope of analysis in financial statements is limited

Financial statements provide a limited scope of analysis and may not reflect all aspects of a borrower's financial health. This can result in a lack of visibility into important financial metrics such as cash flows, off-balance sheet liabilities, and contingent liabilities. 

Financial statements only provide information on the financial performance of the borrower and do not cover other important aspects like operational performance, strategic plans, or market position. Additionally, they may not reflect the full value of certain intangible assets like brand value or goodwill.

To overcome this limitation, lenders should request supplementary financial information.

#4 Financial statements can be easily manipulated

Creating a more favorable picture of the borrower's financial position is fairly easy for accounting teams. This can be achieved by manipulating accounting policies, inflating revenue, or deferring expenses. 

To mitigate this limitation, lenders should perform a detailed review of financial statements and consider the reliability of the borrower's accounting practices. In addition, lenders should look beyond financial statements and request supplementary financial information like tax returns, management accounts, and audit reports.

#5 Financial statements cannot always be compared

Financial statements may not be directly comparable between different borrowers or over time due to differences in accounting policies and practices. This can make it difficult to compare the financial position of different borrowers or track changes in a borrower's financial position over time. 

To overcome this limitation, lenders need to standardise the financial metrics they use to assess borrowers' creditworthiness.

#6 Financial statements may involve inadequate disclosure of non-financial information

Financial statements may not adequately disclose non-financial information that could impact a borrower's creditworthiness. Non-financial information includes factors such as regulatory compliance, litigation risks, and reputational risks. Failure to disclose such information could lead to an incomplete view of a borrower's overall risk profile.

For example, a borrower could be facing a significant legal dispute that could have a material impact on their financial position. However, this information may not be disclosed in financial statements and could be missed by lenders during the credit evaluation process. 

Conclusion

Financial statements have several limitations in the lending business, including their historical nature, biasness, limited scope of analysis, the potential for easy manipulation, incomplete financial information, and lack of comparability. 

Despite their limitations, lenders cannot do without financial statements as they provide a standardised, quantitative view of a borrower's financial position. Financial statements provide a starting point for lenders to assess a borrower's creditworthiness and make informed lending decisions. 

To mitigate these limitations, lenders should supplement financial statements with other sources of information and perform a detailed review to validate their accuracy.

Accessing and analysing borrower’s transaction data manually can be too overwhelming when you scale up your business. BankConnect by FinBox helps you automate the heavy work of analysing financial statements, hence reducing the risk of incorrect analysis too. 

Does your business also address thin-file borrowers? Don’t worry, you can assess your customers’ creditworthiness with limited or any formal credit history too. FinBox DeviceConnect provides you with a 360-degree view of borrowers’ financials and behavioural predictors. The underwriting platform evaluates creditworthiness based on alternate to supercharge risk assessment and reduces the possibility of credit losses.