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@example.com or (847) 653-1883.