Do Banks Look at a Company's Balance Sheet or Income Statement When Extending Credit?

As a general practice, banks analyze the financial statements of all companies that apply for credit. The purpose is to judge each company's financial health and decide whether to extend credit or not. Financial statements include balance sheets, income statements and even cash flow statements. By reviewing financial statements before extending credit, banks are complying with regulations and exercising prudence in safeguarding bank shareholders' capital. Statements should be audited by, or at least prepared by, a certified public accountant.

Banks review annual statements covering the last three years, unless the company is new and has no operating history. Banks also require projected financial statements covering the life of the requested loan. A financial statement for a business has three parts. The balance sheet shows assets (what it owns), liabilities (what it owes) and net worth (the difference between assets and liabilities) as of a certain date. The income statement shows revenue that comes into the business from operations and other activities, expenses and the resulting net profit or loss for the period of the statement. The cash flow statement shows cash inflows from operations and investment activities and outflows for business activities and investments.

When the applicant is a closely held company -- that is, one that's not publicly traded on a stock exchange -- the bank will require a personal guarantee of the loan from each owner of the company. The bank must have personal financial statements of the owners to complete the guarantee process.

The balance sheet provides a snapshot of a company's financial health on a certain date. It tells how much debt the company is carrying, how much it owes in trade obligations and how much it needs to collect from customers. It also shows the cash on hand. Components of the balance sheet can be compared as ratios in balance sheet analysis. For example, the current ratio -- current assets divided by current liabilities -- is a test of liquidity showing how much working capital is available to meet current obligations. Another liquidity ratio, debt to equity -- total liabilities divided by owners' equity or net worth -- shows how much the company is leveraging debt against the owners' capital. The bank can evaluate the company by comparing these and other ratios against industry averages.

The income statement shows a company's financial performance over a period of time. It gives the company's revenues (sales) over the period, minus expenses. The types of expenses are the cost of goods sold and selling, general and administrative (SG&A). Operating profit, widely considered a company's true profit, is calculated as revenue minus cost of goods sold and SG&A. Net income, also known as the "bottom line," is the amount of revenue remaining after all expenses, including taxes, have been paid. Profit margins can be compared with other companies in the loan applicant's industry.

The cash flow statement shows how much cash moves in and out of a company over a given period. It shows exactly how much cash the company has generated and how the company is able to pay for operations and future growth. Bank credit analysts look for indications of a company's ability to service debt payments of principal and interest in a timely fashion.