Entity choice is a strategic decision that affects your customers’ legal liability, tax obligations and financial reporting. S corporations and C corporations are two popular choices for private business ownership. Here are some differences to keep in mind when lending to these corporations.

Pinpointing basic contrasts

Unlike partnerships or sole proprietorships, which may expose individuals to unlimited personal liability in certain instances, corporations are legal entities that are separate from their owners. So, the corporate structure limits an owner’s liability for business debts to the cost of his or her stock. A corporation faces generally unfavorable tax treatment, however, unless its shareholders opt to operate as an S corporation. S corporations blend the limited liability of C corporations with the tax benefits of flow-through entities, such as partnerships or proprietorships.

Identifying tax issues

Corporations can elect to be taxed as either a C or an S corporation. The primary difference is that C corporation earnings are taxed twice — first when the company earns income (at the corporate rate) and then when shareholders receive dividends or sales proceeds (at the shareholder’s individual rate).

S corporation earnings flow through to the shareholders’ personal tax returns, avoiding an additional level of taxation. S corporations aren’t taxed at the corporate level and shareholder distributions have no tax effect, since they’re coming from previously taxed income. Instead, S corporation shareholders allocate and claim business income, deductions, capital gains and losses, and tax credits annually on IRS Form 1120S Schedule K-1.

Spotting reporting nuances

Different tax treatments make C and S corporation borrowers look quite different on paper. Most notably, S corporation income statements won’t show federal income tax expense, and their balance sheets won’t include deferred tax assets or liabilities.

Private C corporations, for example, tend to maximize salaries paid to shareholder-employees in lieu of paying dividends. Reasonable salaries are deductible for tax purposes, but dividends are not. This strategy distributes cash to owners while it minimizes the amount of double taxation.

Most S corporations choose shareholder dividends over above-market salaries. That’s because dividends aren’t taxed again.

The tradeoff between owners’ compensation and dividends means that a C corporation borrower could appear less profitable than an otherwise identical S corporation borrower, simply by virtue of its tax-planning strategies.

Modifying due diligence

When comparing S and C corporations, lenders must know these differences and adjust their analyses accordingly to avoid apples-to-oranges comparisons. Always check what type of entity you’re dealing with before reviewing a borrower’s financial statements.

The statement of cash flows is sandwiched between income statement and footnote disclosures in borrowers’ annual financial reports. Much like a middle child, it rarely garners the attention it deserves. But savvy lenders know that it contains valuable information about the sources and uses of their borrowers’ cash.

Cash flows from operations

The statement of cash flows customarily consists of four sections. The first is cash flows from operations, which roughly converts net income from accrual to cash basis.

Net income is the first item listed here. Add backs include noncash deductions (such as depreciation and amortization expense), investment income (or losses) and gains (or losses) from asset sales. Next come changes in working capital accounts, such as accounts receivable, inventory, prepaid assets and accounts payable.

This section provides insight into operating efficiency and effectiveness. Companies that consistently generate negative cash flows from operations won’t survive long. Beware of balance sheet accounts that seem to increase much faster than revenues. Usually working capital moves in tandem with sales.

Cash flows from investing

Next are cash flows from investing activities, such as equipment purchases and divestures. This section tells a lender whether a borrower is reinvesting in the company.

Some distressed borrowers sell non-operating assets — such as idle equipment or marketable securities — as a quick fix to cash flow shortages. But there’s a limit to how long this strategy will work. Eventually fixed asset divestitures compromise a business’s ability to generate future earnings.

Cash flows from financing

The third part displays cash transactions with lenders or investors. Examples of cash inflows from financing activities include new loans and stock issuances. Financing cash outflows include loan payments, dividends and Treasury stock repurchases.

This section provides insight into a company’s blend of debt and equity financing. Mounting debt and forgone dividends may be warning signs of financial distress.

Schedule of noncash transactions

Some important investing and financing transactions — noncash transactions — are reported at the bottom of the statement and, therefore, easily overlooked. Examples include like-kind exchanges, long-term debt refinancing and assets purchased directly with loan proceeds.

Pay attention

The statement of cash flows is often upstaged by the income statement and balance sheet. And, because the statement isn’t always required, small businesses generally don’t prepare one on a regular basis.

Experienced lenders see the statement of cash flows as a critical part of their analytical drill, and request them from potential loan customers. The borrowers’ CPA can assist in their preparation.

Master the basics

Internal controls are processes set forth by an entity’s board of directors, management, and other personnel. According to the Committee of Sponsoring Organizations of the Treadway Commission (COSO), controls should be “designed to provide reasonable assurance [of] the achievement of objectives in the effectiveness and efficiency of operations, reliability of financial reporting, and compliance with laws and regulations.”

COSO lists five components of internal controls:

1.       Control environment. Environmental factors include the integrity, ethical values, management operating style and delegation of authority systems. The “tone at the top” is a fundamental building block for all other control components.
2.       Risk assessment. Companies should be aware of relevant risks and decide on the best ways to manage them.
3.       Information and communication. Enabling employees to fulfill their responsibilities, these systems and processes identify, capture and exchange information. Effective communication ensures information flows down, across, up and outside the organization.
4.       Control activities. These are the policies and procedures that ensure management’s directives are carried out. Examples of control activities are authorization of transactions, accounting reconciliations, supervisory reviews of operating performance, physical security of assets, and segregation of duties.
5.       Monitoring. Companies should continually review and improve internal control performance.

Managers and internal auditors should assess whether internal controls are adequate and explore ways to improve controls. AICPA auditing standards also require external auditors to evaluate their client’s internal controls as part of their audit risk assessment procedures. Auditors tailor audit programs for potential risks of material misstatement, but they aren’t required to specifically perform procedures to identify control deficiencies — unless the client hires them to perform a separate internal control study.

Obtain management letters

The simplest way for lenders to identify internal control problems is to have management letters for every loan file. They provide constructive criticism of a borrower’s control systems from the perspective of an independent third party.

Specifically, Statement on Auditing Standards (SAS) No. 115, Communicating Internal Control Related Matters Identified in an Audit, requires auditors to consider whether controls are sufficient to prevent and detect financial statement misstatements or theft of company assets, as well as whether they enable management to correct misstatements in a timely manner. SAS 115 requires auditors to report any material weaknesses and significant deficiencies (see the sidebar “Which deficiencies make it to the management letter?”), including those remedied during the audit.

Internal controls have been top of mind with auditors since the Sarbanes-Oxley Act passed in 2002. Today, management letters are more in-depth and helpful to financial statement readers.

Auditors disclose findings from prior periods that have yet to be remedied by management. If they continually report the same deficiencies from year to year, lenders should ask why management is reluctant to resolve deficiencies in their controls. Some gaps may seem minor — separating billing and cash receipts in a small family business, for example. But other gaps may put you at excessive risk.

Ideally, a management letter should accompany a borrower’s financial statements in an audit, but SAS 115 allows auditors 60 days from the audit report release date to compile their findings. If the management letter has been omitted from a borrower’s financial statements, ask for a copy as soon as it’s available.

Think like an auditor

Sometimes lenders have to think like auditors. This mindset can help you assess risk factors that could lead to delinquent payments and loan defaults. Internal controls are a big part of an auditor’s risk assessment. A solid system of internal controls can ensure that your borrowers prevent, detect and correct financial misstatements. Weak controls can result in costly theft or embezzlement, misstatements and errors.

Sidebar: Which deficiencies make it to the management letter?

Under SAS 115, management letters must identify “material weaknesses” and “significant deficiencies” in internal controls discovered during audit procedures.

The more egregious of the two shortcomings, “material weakness”, refers to “a deficiency, or combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected on a timely basis.”

A significant deficiency is “less severe than a material weakness, yet important enough to merit attention by those charged with governance.” Note that a control deficiency is dependent on the potential for misstatement; misstatement need not actually have occurred.

SAS 115 permits significant leeway in how auditors classify internal control weaknesses, such as lack of segregation of duties, inadequately trained accounting personnel, restated prior period financial statements, and material audit adjustments.

When classifying deficiencies as material or significant, auditors evaluate the probability and magnitude of the potential misstatement. They also consider “compensating controls,” which are substitute procedures that limit the potential of a deficiency to result in an actual misstatement.

8 questions to consider in M&A deals

 With priced-right sales opportunities ripe for the picking, some of your customers may be tempted to acquire another business as the economy mends. Others — those feeling the strain of the prolonged downturn — may be considering a merger with another stronger business.

 In either scenario, you may be asked to provide financing. Here are some questions to consider as you sort the potential winners from losers in a merger or acquisition deal.

 1. What are your borrower’s strategic motives? Before devoting substantial resources to due diligence procedures, identify the borrower’s strategic motives for acquiring another company. For instance, is it seeking economies of scale, production synergies or personnel from the deal? Acquisition targets that won’t accomplish the borrower’s overall strategic goals are a poor fit.

2. Does your borrower have a competent due diligence team? Problems may not be apparent to borrowers in an acquisition mode. In the midst of negotiations, due diligence can help your customer gauge success or failure. Business owners typically put together a due diligence team with managers from their company’s functional departments. These in-house experts can help assure lenders that all risk factors and contingencies have been addressed.

3. Are you satisfied with the due diligence findings? Before approving the loan request, determine what procedures were used in the due diligence process, and make sure you’re comfortable with the due diligence team’s performance. When due diligence is performed too hastily or its scope is too narrow, the borrower may overlook important risk factors, such as contingent liabilities, concentration risks and employee retention problems.

4. What’s the financial forecast? To get a sense of the acquisition target’s historic and future earnings, the due diligence team should make sure income and cash flow projections are complete and reasonable. Balance sheet items also should be investigated, and assets inspected to evaluate overall quality and obsolescence. Contingent or unrecorded liabilities, as well as whether the company is complying with federal, state, sales and employment tax obligations, also should be examined.

5. Have operations been properly analyzed? The due diligence team should tour the target’s facilities and, if possible, interview key personnel, customers and suppliers. The goal should be to identify company-specific risk factors, including obsolete assets, concentration risks and poor internal controls. The borrower’s production manager should flowchart the target’s production process on site to identify core competencies and operating maladies.

6. How does IT fare? The business’s IT should be up-to-date and compatible with the borrower’s systems. When the target company must integrate new IT systems, it will take time and money to get the seller’s employees up to speed. Postmerger IT integration requires a detailed action plan to avoid business interruptions, such as delayed deliveries and lost purchase orders.

7. What about human resources? Among a company’s most valuable — but transitory — assets are its employees. The compatibility of corporate cultures is key. The due diligence team must review the target’s HR policies and determine how salaries and benefits will change after the proposed merger or acquisition. To improve employee retention and guarantee the seller’s ongoing cooperation after the deal closes, employment contracts, noncompete agreements or consulting arrangements also must be reviewed.

8. What are your customer’s postmerger expectations? Beware of the unrealistic. Purchase prices are typically based on projections of future income streams, including future cost savings and revenue opportunities. Many transactions fail because purchasers overestimate acquisition synergies and economies of scale. Borrowers also may overlook the full costs of improving production or integrating two companies into one. Make sure your customers devise detailed action plans.

Unearthing not-so-obvious risks and liabilities is multilayered: Lenders should perform industry risk analyses, interview management, request additional documentation and pay attention to business community word-of-mouth. The following questions are meant to help you uncover some of the potential risks and liabilities that can compromise debt service.

1. Is there an overreliance on certain customers? Companies that rely on any one customer for more than 10% of their annual sales (or one supplier for more than 10% of their materials) risk sudden interruption of operations if the customer (or supplier) cuts its ties. Well-written, long-term contracts are one strategy to combat concentration risks.

2. Is there an overdependency on key people? Lenders should evaluate the age and health of key people and the cost to replace them. Volatile employee or shareholder relations may increase the risk of losing a key person. Signed noncompete agreements and key-person life insurance policies may minimize the stress caused by a key employee’s sudden departure.

3. Are there tax problems? When compounded with interest and penalty charges, tax liabilities can quickly take a toll on a business. Lenders should stay abreast of any customers being audited for income, sales and payroll tax deficiencies.

4. Are there any ongoing lawsuits? Pending litigation is expensive, and it can distract management’s attention from the company’s day-to-day operations. Bitter shareholder disputes may even result in court-mandated liquidations.

5. Is there a high risk of fraud? A strong internal control system is the best defense against fraud risks. While most companies worry about employees stealing assets, lenders should also watch out for managers using fraud schemes to misrepresent the financial health of the company.

6. Are there foreign transactions? In addition to obvious geopolitical risks, foreign activity is susceptible to repatriation and foreign-tax issues, exchange-rate risks, or the possibility that a foreign government might expropriate (or repossess) the company’s foreign property.

7. Are there environmental risks? Environmental regulations may require a business to clean up its own property, even if a previous owner caused the contamination. Routine environmental assessments can help manufacturers and processors keep environmental clean-up costs to a minimum.

Value is in the eye of the beholder. As a lender you often have a stake in private company mergers and acquisitions. So it’s important that you know whether the target’s price is reasonable and that the buyer is emotionally detached. After all, a buyer that overpays is more likely to experience financial problems after the deal closes.

Procuring a professional appraisal upfront can mean the difference between a long-term lending relationship and default. Expert opinions also can assuage any concerns you may have, such as whether income projections are reasonable or comparables are truly similar to your borrower. And knowing business valuation terminology, methodology and potential pitfalls will help you make informed lending decisions.

Standard of value

The term “value” can have many different meanings. Strategic (or investment) value refers to the perceived value to a specific investor. A business seeking to increase market share, for example, might pay a premium to acquire a competitor. Strategic value depends on an investor’s individual situation, requirements and expectations.

An important benchmark in negotiating deals is fair market value. Essentially, this is the price the “universe” of potential buyers and sellers would agree on for a business interest. Fair market value assumes no compulsion to buy or sell and reasonable knowledge of all relevant facts. Beware of deals where strategic value is significantly higher than fair market value. Many buyers overestimate the value of synergies.

Another common standard of value is fair value. In an accounting context, it’s similar to fair market value, except that it’s an exit (rather than an entry) price. Moreover, fair value only considers market participants active in the principal (or most advantageous) market.

Accountants use this term when, for financial reporting purposes, they value assets and liabilities such as intangible assets (customer lists, non-competition agreements, etc), goodwill and contingent payment obligations. Some borrowers may have reported goodwill impairment during the recession, for example. This occurs when the fair value of acquired goodwill is lower than the amount shown on the borrower’s balance sheet. These write-offs may foreshadow financial problems.

Methodology

Appraisers apply three approaches to valuing a business:

Cost (or asset-based) approach. The value of a business is the difference between its assets and liabilities. For example, an appraiser might revalue the amounts shown on a company’s balance sheet. This approach is difficult to use on companies with significant intangible value. It’s typically reserved for holding companies and others that rely exclusively on hard assets.

Market approach. This approach generates pricing multiples from sales of comparable (or guideline) companies. Here, value is a function of the ratio of (multiple) selling price and a financial metric, such as annual revenues or last year’s earnings before interest, taxes, depreciation and amortization (EBITDA).

Pricing data can be obtained from daily stock market quotes and, private, proprietary databases.
Selection criteria for comparables might include transaction date, financial performance, industry and size, for example. Finding a meaningful sample of comparables for some companies — especially niche specialists — can be difficult.

Income approach. Appraisers project cash flows and then discount them back to their net present value. Discount (or capitalization) rates are based on the company’s risk profile. High-risk businesses are assigned a higher discount rate, which equates to a lower value (and vice versa).

The income approach may be difficult for laypeople to understand. Sophisticated buyers and sellers are more likely to use this approach. It’s often the preferred method for startups and companies with significant intangible value.

Pitfalls

Methods and definitions explain some of the “science” underlying business valuations. But accurate appraisals also require finesse and qualitative assessment. Experienced appraisers understand subtle valuation nuances and potential pitfalls.

For example, some sellers try to save money by reusing an appraisal prepared for, say, a previous gift tax return or shareholder buyout. Not only can these valuations be out of date, they may include inapplicable valuation discounts or use an inappropriate standard of value.

Valuations are only valid as of a specific date and for a specific purpose. Therefore, borrowers always should check with their appraisers before recycling an old report in a new context. Do-it-yourself valuations present another minefield of potential problems. The IRS and U.S. Small Business Administration recognize the importance of appraisal training and have established “qualified appraiser” criteria.

Before you finance a deal, ask whether the parties have consulted with valuation professionals. Ask for a copy of the written appraisal report, including the financial exhibits and appraiser’s curriculum vitae. Reliable appraisers have years of valuation experience and have credentials from professional appraisal organizations.

Educated decisions

Filtering through the data and arriving at an accurate value requires mastery of both the art and science of business appraisal. Lenders who understand valuation basics and expect borrowers to obtain outside valuation expertise will have a higher likelihood of making wise lending decisions.

Sidebar: Rule out “rules of thumb”

You’ve likely heard at least one valuation formula, such as one times revenues (for professional practices) or five times earnings (for manufacturers). But borrowers and lenders who bank on these “rules of thumb” may be in for a rude awakening after closing.

Oversimplified formulas overlook unique operating characteristics, such as nonoperating assets, exclusivity contracts or in-process research and development, which differentiate the subject company from its competition. Rules of thumb also may be outdated. For example, a valuation formula popularized during industry consolidation in the mid-1990s may not be relevant in today’s turbulent economy.

Another reason to shun rules of thumb is their ambiguity. To illustrate, does “earnings” refer to net income, pretax earnings, earnings before interest and taxes (EBIT), or some other metric?

Purchasing is centralized

Purchasing should be the responsibility of one individual — or a single department for large companies. This person, or department, is tasked with negotiating with suppliers for the lowest price, greatest flexibility and highest quality.

The procurement manager also tracks the reorder points for inventory, supplies and equipment. Consolidated orders are larger and made less frequently, which results in volume discounts and reduced shipping charges.

Information is shared

Demand-driven businesses match inventory levels with customer demand. Enterprise resource planning (ERP) software facilitates supply chain efficiency by enabling customers, vendors and middlemen to share information. ERP systems also improve customer service, as well as minimize production delays and overtime costs.

Budgets and forecasts should be updated monthly or even weekly, if possible. That way, everyone along the supply chain knows what will be needed — and when.

“Preferred vendors” are used

Companies should have a short list of preferred vendors with whom they’ve negotiated the best prices and terms. It’s especially important for lean manufacturers to have suppliers that are flexible and provide reliable quality.

Most vendors stop by annually to renegotiate price and discuss service issues. The procurement manager should prepare for supplier negotiations by reviewing forecasts and historic spending patterns to determine volume, average order size and expected demand. To maximize bargaining power, he or she also should know what the competition offers.

Shipping policies are tight

Fuel prices affect shipping charges. Depending on the balance of power in a borrower’s supply chain, some companies can pass along increased costs with fuel and shipping surcharges. But many cannot.

Efficient borrowers discourage small batch orders of supplies and inventory, as well as overnight and 2-day shipping options, which cost about 40% more than standard ground delivery. To optimize shipping efficiency for finished goods, some companies purchase transportation and logistics software — or they might outsource shipping functions to a third party logistics provider.

High shipping costs are causing many companies to re-evaluate their offshoring contracts. The incremental shipping costs from, say, China or India may negate any cost savings from cheaper materials and labor. Moreover, domestic suppliers often are more flexible and provide fewer communication barriers.

Inventory practices are lean

Lean (or just-in-time) operations strive to eliminate non-value-added activities (such as downtime, setup, inspection and scrap) and minimize the amount of working capital tied up in inventory. Lean borrowers expect suppliers to ship inventory at the last possible minute and then ship finished goods to customers just as quickly.

Lower inventory balances also mean lower storage, security, obsolescence, pilferage and insurance costs. Business owners who worry that decreased inventory levels will compromise customer service can rate customers based on volume and profitability. They then can base safety stock levels on these ratings.

Outside assistance is sought

Supply chain efficiency is an important consideration when evaluating the creditworthiness of existing and prospective borrowers. An outside expert can help borrowers reinforce their management skills by forecasting demand, benchmarking performance against industry best practices and setting realistic improvement targets.

Re-evaluating controls in a recession

There’s no time like the present to focus on internal controls. For many, the recession has slowed business operations. Borrowers can use the downtime to assess and enhance internal controls.

Unfortunately, recessions also entice some employees to commit fraud. For example, a CFO may feel pressured to achieve unrealistic performance goals. Or a part-time clerk may be living beyond his or her means. Strong internal controls not only detect fraud, but they also prevent employee dishonesty from beginning.

Covering all the bases

Lenders should be on the lookout for these three basic controls that differentiate strong internal control systems from weak ones:

• Physical restrictions. Employees should have access to only those assets necessary to perform their jobs. Locks and alarms are examples of ways to protect valuable tangible assets, including petty cash, inventory and equipment. But intangible assets — such as customer lists, lease agreements, patents and financial data — also require protection. Passwords, access logs and appropriate legal paperwork help serve this purpose.
• Account reconciliation. Management should confirm and analyze account balances on a regular basis. To illustrate, strong borrowers reconcile bank statements and count inventory on a regular basis.Interim financial reports, such as weekly operating scorecards and quarterly financial statements, also keep management informed. But reports are useful only if management finds time to analyze them and investigate anomalies. Supervisory review takes on many forms, including observation, test counts, inquiry and task replication.
• Job descriptions. Another basic control is detailed job descriptions. Company policies also should call for job segregation, job duplication and mandatory vacations. For example, the person who receives customer payments should not also approve write-offs (job segregation). And two signatures should be required for checks above a prescribed dollar amount (job duplication).

Taking matters into your own hands

Sarbanes-Oxley requires auditors to attest to the effectiveness of their public clients’ internal control systems and report any material weaknesses. Although private companies aren’t bound by these requirements, every business benefits from reinforced controls. A financial professional can help private companies evaluate internal controls and remedy any apparent weaknesses.

Check out the statement of cash flows

Although business owners and lenders tend to cast it aside, the statement of cash flows can reveal clues about an existing or prospective borrower’s performance, especially the owner’s ability to manage cash. The statement of cash flows typically consists of three sections:

• Cash flows from operations. This section converts accrual net income to cash provided or used by operations. All income related items flow through this part of the cash flow statement, such as net income; gains (or losses) on asset sales; depreciation and amortization; and net changes in accounts receivable, inventory, prepaid assets, accrued expenses and payables.
• Cash flows from investing activities. If a company buys or sells property, equipment or marketable securities, the transaction shows up here. This section could reveal whether a company is divesting of assets for emergency funds or whether it’s reinvesting in future operations.
• Cash flows from financing activities. The third section shows transactions with investors and lenders. Examples include treasury stock purchases, additional capital contributions, debt issuances and payoffs, and dividend payments.

Below these three categories is the schedule of noncash investing and financing transactions. This portion of the cash flow statement summarizes significant transactions in which cash did not directly change hands: for example, like-kind exchanges or assets purchased directly with loan proceeds.

Inquire about significant changes

The statement of cash flows shows changes in balance sheet items from one accounting period to the next. Lenders should inquire about significant balance changes. For example, if accounts receivable were $1 million in 2007 and $2 million in 2008, the change would be reported as a cash outflow from operations of $1 million. That’s because more money was tied up in receivables in 2008 than 2007.

An increase in receivables is common for growing businesses, because receivables generally grow in proportion to revenue. But a mounting receivables balance also might signal cash management inefficiencies. Additional financial information — such as an aging schedule — might reveal significant write-offs, which is important information if you’re a lender that relies on accounts receivable as collateral.

Also beware of businesses that continually report negative cash flows from operations. There is a limit to how much money a company can get from selling off its assets, issuing new stock or taking on more debt. When operating cash outflows consistently outpace operating inflows, it’s time for intervention.

Find hidden sources of cash

Outside financial professionals can breathe new life into a cash-starved business. And their expertise is in high demand during economic downturns. Here are some ways they can help borrowers stave off the cash crunch:

Control growth.

Companies that grow too fast experience growing pains. Cash shortages result from the operating cycle: Before they receive payment from customers, they must fork out substantial sums to pay employees, rent facilities, build product, etc. Out-of-control growth also can impair quality, which, in turn, hurts goodwill and long-term viability.

Putting the brakes on growth may be a hard pill for entrepreneurs to swallow. But slow sustainable growth usually is better over the long term. An accountant can help borrowers compute their “fundable growth rate,” the growth rate at which cash inflows equal cash outflows.

Trim fat.

Struggling companies can restore cash reserves by curbing quasi-business expenses (such as luxury vehicles and business trips), laying off nonessential workers, avoiding advance purchases, selling off nonoperating assets or repaying shareholder loans.

Convert expenses from fixed to variable.

For example, borrowers might consider outsourcing, temporary labor and equipment leasing to generate cash. They also might re-evaluate their tax planning strategies, which may be outdated under current economic conditions and the new U.S. administration.

Upgrade asset management.

A financial professional can identify weaknesses in asset management and offer solutions. For example, accounts receivable collections might improve with tighter credit policies, early-bird discounts, collections-based compensation programs and dedicated collections personnel.

Conversely, some companies carry too much inventory. (See “Lean companies are healthy borrowers” below.) In addition to tying up working capital, inventory incurs hidden costs, such as interest, storage and insurance expenses.

Keep a watchful eye

By donning their detective caps, lenders can prevent unwise credit decisions. For existing borrowers, your diligence can identify problems and help find solutions that minimize the risk of default.

What’s worrying CFOs, exactly?

“Throughout the history of our survey, CFOs have shown remarkable ability to predict future economic conditions,” warns John R. Graham, director of the Duke/CFO survey, which was published last December. Senior financial executives are in the trenches and know firsthand how internal and external factors affect their businesses.

Many of early 2008’s top concerns — rising fuel and commodity prices, supply-chain risks, and attracting and retaining employees — were put on the back burner by year end. Now CFOs are most concerned about:

Consumer demand.

U.S. consumers are worried about high energy and grocery prices, job security and declining property values and are, as a result, postponing major and unnecessary purchases or looking for deep discounts. Consumer spending habits trickle down through the economy. In 2008, retailers were especially hard hit by waning consumer demand. Now it’s manufacturing’s turn.

Credit markets and interest rates.

Financial market turmoil is forcing many lenders to tighten their lending practices. In addition to reduced access to loans and credit lines, CFOs report higher interest costs — especially among small businesses and those with low credit ratings. As a result of the credit crunch, many CFOs have forgone profitable investment opportunities.

One business’s accounts receivable is another’s accounts payable. In tough times, it’s important that borrowers continually monitor aging receivables and rethink credit policies to prevent unexpected write-offs.

Forecasting.

Predicting what will happen in the financial markets is more difficult than ever. This uncertainty confounds the management planning process because forecasts and budgets underlie many business decisions, including ordering inventory and supplies, hiring workers and leasing equipment. And forecasting risk can be a double-edged sword. Overzealous forecasts lead to excess capacity and unrecoverable fixed costs, but overly pessimistic ones risk forgone sales. Lenders should review business plans and forecasts skeptically.

Employee morale and productivity.

Employees face a tense work environment. Layoffs abound across all sectors, raises are the exception and pay cuts are becoming common. What’s more, employee retirement account values have plummeted.

The success of many types of businesses — including professional service firms, restaurants and clothiers — hinges on a skilled, established workforce. Business reputation and profits will suffer if employees seek greener pastures or let their own financial worries affect productivity.

What else concerns them?

CFOs also are concerned and uncertain about the new presidential and congressional administration, the housing market fallout and balance sheet weaknesses. Of these, the last should be particularly disconcerting for lenders who collateralize loans based on the book values of tangible assets.

In particular, CFOs in the transportation, media, technology and health care industries express mounting concern about whether their balance sheets accurately portray asset recoverability and market values. This year may bring record numbers of impairment losses for long-lived assets (such as property and equipment) and indefinite-lived intangible assets (such as acquired goodwill or brand names) in these sectors.

How are CFOs reacting?

Proactive CFOs think of ways to counteract business threats. For example, sales and promotional campaigns might counter waning consumer demand and, therefore, increase revenues. Alternatively, performance-based compensation programs might enhance employee morale and productivity.

As the economy limps forward, many companies are in “survival mode.” The CFO survey predicts that in 2009 U.S. companies will cut employment by 5%, outsourced labor by 2%, capital spending by 10%, technology spending by 4%, and marketing and advertising costs by 7%. Despite their corrective actions, CFOs expect average annual profits to decline by 9%.

What can you do?

During a recession, keep your strong borrowers close, your weak ones closer. Communicate often and openly — don’t wait until year end to find out how your borrowers are faring — and ask what’s keeping them awake at night. More important, how are they taking charge of adverse conditions?

Above all, remember that the market is cyclical and will eventually recover. Lenders who stand by borrowers in both good times and bad build profitable, enduring business relationships.