Getting a business loan is as easy as one-two-three. One, have good information. Two, be well prepared.
Three, make sure you understand exactly what your credit request is.
But wait. It’s not that cut-and-dried. Several subjective judgments factor into a banking institution’s final loan decision.
“We don’t put the numbers into a black box, turn the crank and spit out yes or no,” says David Janus, president of FirstMerit Bank’s Cleveland Region. “I can take three bankers, put them in a room and give them the same set of financial statements, and they won’t identify exactly the same things. So it is subject to interpretation.”
Smart Business asked Janus how our readers can improve their chances of getting a bank loan.
What determines the fate of a typical loan request?
The first thing the bank asks is what the loan is for, and it’s not always crystal clear or readily apparent. If somebody says they need the money for a new machine, that’s pretty obvious.
Where it gets tricky is when a company says it’s growing rapidly and needs more working capital or an increase in its line of credit. The bank will study the balance sheet to understand changes in the accounts receivable, inventory and accounts payable, because that’s really what the line of credit is financing. The bank also looks at sales, earnings and cash flow. Are receivable turns slowing down? Has the company had some credit losses? Has a customer filed for bankruptcy? Are collections poor?
I’ve seen instances where customers wanted money because they were growing fast, but they had too much money tied up in receivables and inventory and were starving for cash. Once the request is understood, the financial analysis begins.
What are the important financial considerations?
Think of the basic approach as the sides of a triangle where the sides are represented by cash flow, collateral and equity capital/leverage.
Cash flow is what repays the loan. Banks have minimum policy guidelines for debt service coverage ratio, and basic acceptance is often at least 1.2x coverage, as a cushion provides for the unexpected. The bank looks at the cash flow leverage, too, using a measure of debt/cash flow.
Next is collateral, which generally means receivables, inventory, machinery and equipment, and real estate. The bank discounts the stated values of the collateral to better align the total with what the bank would realize in a default, and then makes sure that amount would cover the loan. This all gets tricky in the brave new world of less manufacturing, because many companies especially service businesses don’t have machinery and equipment, and fewer have inventory.
Finally, there’s equity capital and leverage. Bankers ask what the company’s net worth is relative to debt. Is it well capitalized or thinly capitalized? Does the company leave money in the business or distribute it?
Capital structure dictates overall strength of company and what kind of shock it can take. If it has a couple quarters or years of poor earnings, is the company strong enough to weather the storm? Does it have enough borrowing capacity? Is it financially strong, or is it leveraged too high? If it’s over-leveraged, it could collapse like a house of cards.
What’s the subjective part of processing a loan request?
It’s the interpretation of the numbers and an assessment of what’s going on in the business, the industry, management’s skills, and other characteristics.
If somebody needs a very minor increase in their line of credit and they’re doing well, it’s a pretty easy loan request. If somebody’s buying another company and they’re tripling the amount of the debt while tripling the size of the company, banks have to determine if management has the skills to handle it as well as the viability of their business plan.
How can a loan be structured?
The output of the financial analysis determines how a bank structures a transaction in regard to personal guarantee support, pricing and fees, term of loan, repayment schedule, reporting requirements, additional collateral needs and covenant structure just to name a few components.
Are any other factors important in securing a bank loan?
It helps to have a good relationship with the banker.
Applicants should also have good quality information, be knowledgeable about what’s going on in the business and knowledgeable about the numbers. They should have a financial plan, a projection for why they need the money and supporting information. They need a good understanding of what’s happened in the past, and be able to clearly explain risks and how they mitigate those risks. We’re in the risk business, and if the borrower can help us mitigate the risks, so much the better.
DAVID JANUS is president of FirstMerit Bank's Cleveland Region. Reach him at email@example.com or (216) 694-5658.