The lifeblood of most businesses is money. Unless the company’s ownership and management principals are quite wealthy, the source for much of a firm’s operating capital and money for capital improvements is usually a bank loan.
While some business owners are anxious about applying for a bank loan, there really is no magic involved in getting a business loan approved. There is, however, a series of steps that must be taken before any bank will approve a loan. Knowing ahead of time what the bank expects from customers applying for a business loan makes it much easier to be prepared for the loan interview and improves the odds of the bank saying yes.
Smart Business turned to Sue Zazon, president and CEO of FirstMerit Bank in Columbus, for a look at how banks make credit decisions.
What paperwork should a business have available at the time of making its loan application?
The paperwork needed for a loan depends on the complexity of the transaction. It is very important that the loan’s purpose be clearly defined. If you have a relationship with a banker, a conversation regarding the information essentials is helpful. The borrower should have good quality financial information, be knowledgeable about the numbers, be knowledgeable about why he or she needs the money and also have a plan for repayment.
What kinds of financial considerations or ratios are you looking for with a business loan?
When I initially look at a loan request, I assess three factors.
- I look to the owners/managers of the business and their demonstrated ability to continue to manage the company profitably.
The people that manage or own the business are the most critical factor in my decision.
- Cash flow to repay the debt. If it is term financing, a rule of thumb is a debt-service coverage ratio of 1.2 times. The bank looks
at the cash flow leverage too, using a measure of debt to cash flow.
- Collateral, which is usually receivables, inventory, machinery, equipment and real estate. The bank generally discounts the value of the collateral to better align the total with what the bank would realize in a distressed situation.
Is the entire process objective, or do other factors come into play?
The entire process is both objective and subjective. The numbers are objective. The interpretation of the numbers, management’s capacity, industry considerations and financial projections are all subjective. I think business lending is subjective, which is why it is so important to have a strong relationship with your bank.
What ultimately determines the fate of a loan request?
The fate of a typical loan request is determined initially by what the borrower is using the money for. If it is to refinance a piece of real estate or to buy a replacement piece of machinery, the existing cash flow should cover the new debt. It gets tricky when a company asks for an increase in its line of credit because cash flow has gotten tight. The bank will analyze the balance sheet to understand the changes in accounts receivable, inventory and accounts payable, because that is what the line of credit is financing.
We ask questions. Is the money needed because receivables have not been collected as fast as anticipated? Is there a charge-off of bad debt? Is it a need based on revenue growth? It could be a combination of all of them.
If someone is buying another company and tripling the amount of debt while tripling the size of the company, banks have to determine the viability of the management team and the business plan. If the request is a small increase in its line of credit and the company is doing well, it’s a pretty easy loan request. Once it is very clear about the use of the money, the analysis begins. A good relationship with a bank is essential — especially when the loan requests become more complicated. Banks tend to be more flexible when the opportunity is well organized and thought out. The bank is in risk business, and when the borrower can clearly explain those risks and the mitigants, the process is much more streamlined.
SUE ZAZON is president and CEO of FirstMerit Bank in Columbus. Reach her at (614) 545-2791.