Your business is growing, and it’s
time for a loan. How does a bank
assess the strength of your company? How does it decide if it can lend you
money either through a line of credit or
through a term loan?
These are just some of the questions
business owners commonly ask when
pursuing a loan, says Joe Miltimore, SVP,
commercial division manager of MB
Financial Bank in Chicago.
Smart Business spoke with Miltimore
about what a bank’s perspective is when
determining whether to loan money to a
company and how a company might better position itself once it applies for a
loan.
How does a bank assess the strength of a
company in the decision on whether to
grant it a business loan?
Most commercial banks consider a
number of factors when making credit
decisions. The two most crucial factors
are historical and projected cash flow
and the quality of collateral.
How does a bank decide if it should lend a
company money through a line of credit or
a term loan?
There are important differences between a line of credit and a term loan. A
term loan is used to finance the acquisition of a fixed asset, such as equipment,
land or a building. A line of credit is put
in place to help a company manage the
timing difference between issuing a customer invoice and collecting the invoice.
Businesses have ongoing bills, such as
payroll, utilities, insurance, raw material
vendors, etc., that need to be paid before
they collect their invoices. A line of credit allows a company to borrow against
its invoices so it can pay its ongoing
operating expenses. Once its customers
pay the invoices, the company pays off
the line of credit.
A good way to remember the difference between a line of credit and a term
loan is to consider the use of the borrowed funds. If the funds are used to
acquire fixed assets, the appropriate credit facility is a term loan. If the funds
are used to help manage timing differences between issuing invoices and collecting on them, then a line of credit is
appropriate.
What should a company look for in a bank
when deciding where to pursue a loan?
There are mainly two types of borrowers. For type one, the only concern is the
cost of borrowing, which is the interest
rate. Type-two borrowers are concerned
with the cost of borrowing and maintaining a relationship with the bank. The
sole focus of type-one borrowers is to
select the bank with the lowest interest
rate. Those types of borrowers should
call 10 banks and choose the one with
the lowest interest rate.
Type-two borrowers should focus on
whether the bank has a reputation as a
‘relationship’ bank. The goal of a relationship bank is to retain its customers
for a long period of time and, to accomplish this, it has to get to know them very
well. This includes knowing the owner(s) and manager(s), understanding
how the company operates and what factors influence its success. It also has
to understand the customer’s industry
and keep abreast of changes that might
affect the success of the customer’s
company. When a bank understands
these things, it’s in a better position to
‘add value’ to the customer.
What can a company do to strengthen its
likelihood of obtaining a loan?
Most banks place great importance on
cash flow and collateral. There are many
definitions of cash flow. The simplest
measure is the company’s EBIDA (earnings before interest, depreciation and
amortization expenses). EBIDA is compared to the company’s debt service
(principal and interest [P&I] payments
on bank debt). Most banks prefer to see
EBIDA equal to or greater than about
125 percent of P&I payments. Banks
usually look at the ratio of EBIDA to
debt service both in recent years and in
the future (based on the company’s projections). But looking at this ratio alone
doesn’t tell the full story of the company’s financial health. This is where being
associated with a relationship bank is
important because it looks beyond the
ratio of EBIDA to P&I in making credit
decisions. Generally, businesses should
do all they can to maximize EBIDA.
From a collateral perspective, any
company should try to maintain the quality of its assets. This means keeping its
equipment and building in good condition and as unlevered as possible. It
should try to acquire assets that have
multiple uses, as they’re more valuable
than ones that are very specialized. Also,
it should try to maintain the integrity of
accounts receivable and inventory. A
bank will lend more against receivables
and inventory if there’s minimal history
of bad debt write-offs or ‘stale’ inventory
charge-offs.
JOE MILTIMORE, SVP, is commercial division manager of MB Financial Bank in Chicago. Reach him at [email protected]
or (847) 653-1883.
