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Tax Returns-102733-edited.jpgHas your customer ever questioned why their personal tax returns are needed during the application process? Most banks know why they are required, but are you fully utilizing the financial information that is available within the document. Banks require current tax returns from prospects as a condition of making a commercial loan. They expect them as a prerequisite for prudent underwriting and ongoing loan monitoring. And they employ tax returns for calculating a borrower’s cash flow and for generating ability, debt leverage, and liquidity position. While they may fully comprehend all of these uses, most borrowers understand that their tax return is an essential document that banks and lenders need for determining their creditworthiness.

Despite this awareness on both sides of the loan desk, tax returns remain one of the most underutilized instruments in banking. Given all the recent news and discussion about tax policies, we thought it would be helpful to review some of the many reasons why banks want and need the information contained in a tax return.

  • Authenticity: Information contained in a tax return has been filed with the IRS, confirming its validity. You can not make the same assertion of financial statements prepared by the borrower or even by an auditor.
  • Usefulness: Financial information contained in a tax return tends to be more encompassing and detailed than many GAAP prepared income, balance sheet and cash flow statements.
  • Insightfulness: Detailed schedules contained in a tax return offer useful information about the borrower’s financial and non-financial matters, including other banking relationships, financing opportunities, cash balances, risk tolerance, organizational structure, investments, and charitable giving.

The validity, details, and insights contained in a tax return are important for banks and lenders. How the information informs cash flow analysis is critical. It enables lenders to accurately calculate cash flow to calculate the ‘probability of repayment’ – the likelihood that the loan will pay as agreed.

The most common measure of cash flow, EBITDA (earnings before, interest, taxes, depreciation, and amortization) indicates the ability of the borrower to generate cash flow to repay its debts and is the most significant predictor of creditworthiness. By adding back interest and back taxes, along with (non-cash) depreciation and amortization, lenders gain a complete perspective on the borrower’s ability and the likelihood of paying back the loan.

Tax returns provide insights that other financial statements cannot offer. You can rely on information such as EBITDA or free cash flow from operations for the confirmation of the creditworthiness of commercial borrowers. If your bank is not making full use of the information found in tax returns as part of your underwriting process, it’s likely you’re missing a vital loan monitoring tool resource.

The HORNE tax team is available to help you put this critical information to use to secure your lending practices.

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Brent is an assurance supervisor in financial institutions at HORNE LLP. He serves clients in internal and external audit capacities for both securities and exchange commission (SEC) and privately-held institutions while also performing Sarbanes-Oxley testing, loan review procedures, employee benefit plan audits and financial-statement preparation.

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