The Importance of Verification of Liquidity
As financial institutions continue to try to grow their Balance Sheets and more specifically their assets, their common goal is to book quality loans that will perform and amortize through the life of the loan. However, that isn’t always possible as downturns in the economy, increases in material costs or rising interest rates are a few factors, but not all, that can affect a borrower’s capacity to repay their debt. A few ways financial institutions will try to protect their assets is through sufficient collateral to cover the outstanding balances on the loans with adequate collateral margins in case collection on the debt is necessary. Additionally, ensuring the borrower’s cash flow is sufficient to service the specific debt requirements is essential in determining whether or not the borrowers can repay the annual debt requirements for the relationship and if the loan is one that the financial institution would like to fund.
A few supporting factors that go into determining the borrower’s capacity to repay the debt is collecting balance sheets and personal financial statements. Recording this data will help the banks assess where all the assets are for the corporation or the personal guarantors. However, as we are all aware, some borrowers inflate their assets and decrease their liabilities to appeal more to financial institutions and represent a greater net worth than what actually may be correct. The most important factors for financial institutions when analyzing financial statements are not only the different ratios determining leverage, but also how much liquid cash is available to service the annual debt in cases where the cash flow is insufficient. Liquid cash can come from several different sources such as cash in various financial institutions, stocks and bonds (marketable securities), cash value of life insurance, livestock and marketable crops, to name a few. Knowing how much liquidity the borrower has is vital to determine if the borrower can still repay their debt should the cash flow be insufficient by itself.
But how should a bank protect itself from those borrowers that may inflate their balance sheet to look better to financial institutions? This is where the verification of liquidity applies and can help identify where the liquid assets are and how much is available to service the debt or help with average living expenses should the income not be sufficient enough to cover all of the necessary annual debt requirements.
Financial institutions can help protect themselves by obtaining bank or investment statements, held at different financial institutions, to verify that the balances stated on the financial statements are true and accurate. This should be completed through the application process and prior to funding. But it shouldn’t stop there, verification of liquidity should be part of the annual review process for the larger relationships. Financial institutions expect their larger borrowers to provide annual tax returns and financial statements, but they should also require borrowers to provide financial statements that support the cash balances reported on their financial statements as well. Obtaining the financial statements are not a guarantee that the borrower will use that money to repay the debt, but it helps the financial institution understand the capacity and ability to repay the debt.
Finally, liquidity verification can assist in the grading process. Should the relationship not be able to cash flow based on the income and the debt requirements, liquidity can assist in determining the appropriate grade for a specific relationship based on how much is available compared to their debt requirements. Financial institutions do not want to become asset-based lenders, however, verifying the assets and where they are held will help determine if the borrowers can repay their debt and assigning the appropriate grading scale to that particular asset.