Submitting Financial Statements to a Bank: an Explainer

Now is as good as time as any to explain the difference between unaudited and audited personal financial statements that get submitted to a bank, how a banker looks at personal financial statements, and what crosses the line between normal and criminal.

Personal Financial Statements

A personal financial statement that an individual submits to a bank includes a list of the person’s assets against their liabilities. The asset side of the equation for a rich guy will typically include the following:

  • Cash
  • Marketable securities (think publicly traded stocks, bonds, ETFs, and mutual funds)
  • Personal real estate (their primary residence, pied a terre, vacation home(s), etf)
  • Cash value life insurance
  • Personal property (cars, jewelry, art)
  • Privately held businesses (any business he owns that isn’t publicly traded, including commercial real estate)

The liabilities side will usually have real estate mortgages, credit card debt, home equity or personal lines of credit, car loans, and sometimes accrued tax liabilities.

There is also usually a section that will ask about the person’s annual income, their annual household expenses, and if they guarantee any debt that isn’t listed on their personal financial statements.

These personal financial statements are collected by bankers when the rich guy is either seeking a personal loan from a bank or if they provide a guarantee on a loan for a real estate project or a private business.

Why does a bank need these?

Bankers collect these personal financial statements during the initial underwriting of a loan and then usually once a year during the life of the loan to monitor the credit enhancement provided by the personal guarantee.

With a real estate loan, the banker is going to look at two or three sources of repayment:

  1. How much cash flow (“NOI” or “Net Operating Income”) does the property throw off? The NOI is a real estate-specific metric that looks at how much cash is left over to service debt after all expenses have been taken into account, including normalized vacancy and maintenance expense. Is that cash flow likely to stay the same or increase for the life of the loan, and is it enough to cover the interest and principal payments owed to the bank?
  2. If the projected NOI doesn’t stay the same or increase, either because they lose tenants, rents go down, or expenses go up, a banker will look at the loan-to-value (“LTV”) ratio of the property. The LTV is simple to calculate: divide the loan balance by the market value of the property. Typically a banker will look to have an LTV in the 60 to 80 percent range depending on the location, NOI, type of property, and where we are in the economic cycle. The LTV provides a buffer for the banker in case the market falls, there isn’t enough cash flow to service the debt, and the bank needs to auction off the building.
  3. If the cash flow isn’t enough and the LTV is aggressive, then a banker will ask the rich guy who owns the building to provide a personal guarantee. The personal guarantee is used either (1) to supplement the monthly cash flow (i.e., if cash flow for the month was $1MM but $1.1MM was needed to service the debt, then the rich guy would pony up the difference and inject it into the business, which would then go to the bank to pay the debt service for the month) or (2) to make the bank whole on whatever’s left of the loan after the building has been auctioned.

Misrepresentation is amazingly common with personal financial statements

Banking is a relationship business at the end of the day, and a lot of the rich guys, especially real estate developer rich guys, have massive egos. They’ll often give a banker a personal financial statement that massively inflates their assets. Bankers know this, which is why when they look at a personal financial statement they’ll mentally cross out anything besides cash, marketable securities, and cash value of life insurance. If needed, they’ll put their own estimates on the rich guy’s personal residence and other real estate property.

The values put down for privately held companies are entirely ignored. They’re often hilariously optimistic. It’s also not uncommon for a rich guy to list personal income on a PFS of more than a million dollars but have enough legitimate deductions to report a loss on his tax return. The million dollar cash flow and the reported losses can both be true. It’s just a quirk of our tax code.

The real reason for personal financial statements and personal guarantees

The main reason bankers use personal guarantees on loans is to more closely align the bank’s interests with the owner’s interests. Most owners will work a lot harder and make better deals if they know they’re on the hook if something goes bad. Second worst-case scenario for a banker when he gets a guarantee is that the guarantor actually has to pony up a little money at the end of the whole thing. Worst-case scenario of course is that the banker loses money when all the dust settles, especially if there’s a long, drawn-out court battle between the bank and the rich guy regarding his guarantee.

Hilariously Optimistic vs Criminal

Where the line gets crossed between the common practice of giving inflated personal financial statements to banks and outright fraud is when the personal financial statement includes assets that the guarantor doesn’t actually own. There’s a lot of due diligence a banker can do to ensure the assets being represented on the personal financial statement actually exists, but there’s a lot of things someone dedicated to perpetrating a fraud can do to snooker the banker.

Audited Corporate Financials vs Unaudited Personal Financial Statements

The other area that can cross the line is when someone gives a banker corporate or personal financial statements that are purportedly audited by an accounting firm in accordance with GAAP but in reality either deviate significantly from GAAP or are an outright fabrication. The easiest way to avoid this kind of criminal fraud is to talk to the accountant that did the audit and make sure he works for a well-regarded accounting firm. This doesn’t guarantee the accountant hasn’t been bought off (whether the accountant knows he was or not), but it at least improves the odds.

So many financial statements, so little time

A banker collects so many personal and corporate financial statements every month from almost all of his or her clients that he often doesn’t have time to look through them very carefully. Even if he has a portfolio manager to help him with the credit analysis of the relationship, there’s still no guarantee that every statement is closely analyzed. But since it’s technically a felony to submit falsified financial statements to a bank, to be safe, if you ever have to submit a financial statement, either personal or corporate, consult your accountant first.




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