Whims Of Stingy CURMUDGEONS
Inevitably, at some point during the lifetime of a small business, a necessity to borrow funds will arise.
Perhaps the business needs to add facilities or major equipment, enter new markets or grab more market share. Lack of capital does not have to stifle growth, but in many cases it does.
For example, lack of working capital may lead to a shortage of inventory because the company has missed out on opportunities to take advantage of key buys. This could, in turn, place the company in a position of not being able to meet customer demand. The results would place the business, and its owners, at a competitive disadvantage.
As Esther Schlorholtz, senior vice president of Boston Private Bank and chair of the Massachusetts Community & Banking Council, says, the Massachusetts Community & Banking Council is currently working with banks and other community organizations to create better and more accessible financing options.
These steps are being taken, not only in Massachusetts, but in other states as well. In the undertaking of efficiently satisfying such a need, it is important to impart reasonable expectations as well as a basis for the thought processes behind these expectations.
There is an old adage regarding borrowing money — ‘banks will always lend money when it is not needed.’ When it comes to lending, “credit” is the magic word because at the foundation of borrowing funds is the fact that lenders are in the business of making money. Therefore, they must feel confident the borrower is willing, and able, to repay the principle as well as the interest. Lenders investigate prospective borrowers and weigh key factors in determining whether or not their resulting confidence level meets, or exceeds, the required threshold to justify approving a loan.
When it comes to lending, misguided hopes are easily avoided when taking into account the five “C’s” of credit—character, capacity, collateral, capital infusion and conditions. Many lending institutions factor the five “C’s” as considerations in their analysis to determine the viability of a loan. Over the years, changes in business methodologies, alternative financing structures and information technology have substantially contributed to the automation of the financing process. However, understanding the five “C’s” still remains the key to unlocking the bank vault.
In seeking business financing, many people envision a number of Scrooge-like figures crunching numbers on old calculators in the basement of a dimly-lit, unnamed bank. Despite this notion, loans are not approved or disapproved by mere formulas or the whims of stingy curmudgeons. Although at first glance it may not seem so, lenders are looking for reasons to pass out money. The bottom line is that lenders are in the business of renting money. Arguably, each prospective borrower’s situation and circumstances are undeniably unique. However, most lenders seek to quantify and evaluate the elements common to every loan and then apply their proprietary criteria to the five “C’s” of credit when making lending decisions. Let’s take a look at each of the “C’s” and assess how they may impact a funding request.
JP Morgan, a successful businessman once said that, “I will do business with anyone as long as he/she is honest!” As previously discussed, lenders try to gain context on a case-by-case basis by examining myriad of variables. Recognizing that each loan is unique and the circumstances are particular, the character of the borrower takes on importance.
Of the five C’s, character is the C that is most likely to be influenced by the subjective opinion of the prospective lender. It’s weighting in the decision making process is derived from the initial impression the lender forms regarding the trustworthiness of the prospective borrower, and is codified by the credentials, references, and past performance of the prospective borrower in handling business and personal financial affairs.
It is not uncommon to find entrepreneurs who are stubborn, lack formal education and are oblivious to any and all personal deficiencies. The successful ones have overcome these handicaps by being resourceful, street smart, and sometimes posses a unique intuitive ability that gives them an ‘edge’ not possessed by their competitors. Abraham Lincoln, the 16th President of the United States, puts this in perspective— “Character is like a tree and reputation like its shadow. The shadow is what we think of it; the tree is the real thing.”
“Social conventions are very important,” says Dennis Filangeri, CPA, a spokesman for the Financial Planning Association. Richard Cox, CPA and a spokesman for the American Institute of Certified Public Accountants, states — “Banks are looking for a business that runs their business as a business.” For this reason, educational background, years of business experience and timely satisfaction of obligations, as well as the manner in which a prospective borrower deals with customers, vendors, and employees are reflections, and indications, of character. Borrowers should understand this criteria and realize that it more often adds credence to a proposed loan rather than hinders its approval. After all, lenders are trying to understand the “tree.”
A more obvious part of the loan analysis is the capacity of the borrower to repay the amount issued. This is the “meat and potatoes” of any loan. Inquiries regarding capacity involve reviewing and analyzing a company’s borrowing history. The prospective lender typically considers the number, amount, and type of previous loans, the borrower’s respective repayment track-record and the amount of debt the company’s cash flow can effectively service. Thus, credit risk management becomes an important component of the capacity inquiry. In reviewing a borrower’s ability to repay a loan, lenders will review facts, such as credit history, financial statements and liquid assets, among other pertinent information. This would coordinate with the development and understanding of the business and economic conditions faced by the borrower. In contrast to the other five “C’s,” capacity can, in many cases, ‘make or break’ a proposed loan.
Banks are keen on security, and an impeccable credit history along with stockpiles of cash is unquestionably the best way to assure a lender of recompense. This, however, is generally not the situation. To minimize credit decision risks, banks will use numerous financial benchmarks. Although lending institutions will use different benchmarks some of the more common ones are equity to debt, profit margin and current ratio.
Equity to debt is a ratio which is closely watched by creditors and investors alike because it reveals the extent to which owners are funding operations with borrowed money rather than their own. Lenders interpret a low ratio of equity to debt to include a higher risk of default on loans.
Profit margin is another commonly used benchmark for determining a company’s performance. Lenders want to be confident that there is enough profit available to service existing and new loans.
Current ratio is an indication of a company’s ability to pay its current bills. Generally, the higher the number, the more comfortable lenders are that the company will be able to pay its bills when they are due. Closely related to the current ratio is the quick ratio however, a quick ratio is a more conservative measure. It assumes that a company will only use its readily available cash to pay its bills.
In realistic terms cash, and only cash, can pay bills. The capacity of a business to pay its bills is a function of good cash flow. In generic terms, “cash flow” may be used differently depending on the context. Simply put, cash flow is determined by comparison of available cash to expenses. Borrowers should understand that cash flow plans are not simply glimpses into the future because sooner or later, a borrower will find themselves in a position where they lack the cash to pay the bills. This does not necessarily mean that they are bad businesspeople and probably means that they are normal entrepreneurs who can not accurately predict the future.
Poor cash flow, creating a cash shortfall, is however, the number one reason that businesses fail. This is due to the fact that business owners tend to overestimate their income and underestimate their expenses causing them to simply run out of money. For this reason, lenders will carefully review the cash flow of the business and determine alternative courses of repayment available. A properly prepared business plan, including current and projected balance sheets and income statements, are necessary in determining whether sufficient cash flow exists. Bear in mind, this is not the only criterion for approval of a loan, but a poor cash flow, a poor credit history with few or no references will bode poorly in general.
The idea that collateral is a required element in a loan resonates with many borrowers; however, it is often misunderstood. Banks necessitate security. Collateral, while it does offer a brand of security, is not “money in the bank,” so to speak. Many lending institutions value assets at 50% of their estimated value for the purpose of ensuring complete fulfillment of a loan in the event of a default. Banks will incur expense in the process of transforming the assets into cash. While a significant source of collateral can increase the desirability of a proposed deal, in no way will it guarantee the offer of a loan.
From a lender’s perspective, cash flow will almost always be the primary and preferred source of repayment; and collateral is the last source he or she ever wants to rely on for repayment. Resorting to collateral as a source of repayment means the loan is classified as “nonperforming” and the borrower is in grave financial distress, unless the loan has been made to bridge financial obligations during the penance of the sale of an asset. Collateral typically consists of one or more assets that have been pledged as an alternate repayment source in the event the primary source becomes inadequate to satisfy the obligation. Equipment, vehicles, stocks, bonds, certificates of deposit, precious metals, real property, inventory and accounts receivable are a few examples of the customary types of assets utilized to collateralize a loan. The current market value of these pledged assets, which sometimes requires an independent appraisal, is typically discounted by as much as 20% to 75% depending upon the asset and its current condition to arrive at its collateral value for lending purposes. From a lender’s point of view, these assets are only worth their fire-sale or immediate liquidation value. Keep in mind that use of collateral reduces the risk perceived by the lender, therefore; the process of obtaining a loan may be easier.
Loosely related to the potential of a borrower to compensate their lender is the amount of personal investment on behalf of the borrower. For this reason, capital may be more attractive than collateral to a lender. More precisely, capital infusion is necessary on the part of the business owner insofar as it creates a direct correlation with the prosperity of the borrower to the repayment of the loan.
Capital is also reflected by the borrower’s ability and willingness to save money and accumulate assets. The higher the net worth of the borrower, the more likely that there is a cushion for the repayment of debt in the case of a financial set-back. To illustrate this point consider that Alexander Hamilton brilliantly envisioned a plan after the Revolutionary War wherein the success of the United States would be tied to its wealthiest citizens in the form of securities. The same principle is applied here in directly relating the repayment of the loan to the success and financial flexibility of the borrower. How much would defaulting hurt the borrower? The more it hurts, the safer the bank will feel.
The fifth “C” is by far the most subjective. In interpreting the merits of a proposed loan, most lenders find it prudent to simultaneously scrutinize the conditions related to the economic climate. Specificity relating to the market in which the business operates as well as other pressing factors, such as geographic location, fuse to form an assessment of the inherent risk to the bank. Ten acres in Malibu is clearly more valuable than ten acres in the Ozarks, as a landscaping business in Florida is likely more profitable than a business performing similar tasks in Alaska. These are very basic examples, however, it is quite easy to extrapolate a borrower’s details to convey the same point more resolutely.
Providing an encompassing view of common lending practices can be vital in allaying ordinary fears and false assumptions related to borrowing. There is another “C” which should be considered—culture.
Almost all lenders utilize a computerized proprietary approach to the individual weightings assigned to the five “Cs”. This weighting is based upon the lender’s experience with its existing performing and non-performing loan portfolios. Several software vendors market analytical software to lending institutions which takes into consideration as many as 1,600 independent factors which catalog, analyze, and compare lender’s existing loans to derive the factors all of their performing loans have in common and the factors all of their non-performing loans have in common. Utilizing this analysis, and the conclusions derived from it, lenders typically select 20 to 45 factors and establish acceptable parameters and standards which are then used to evaluate the lending risk associated with future loan applications. The factors include certain must-have positives that are important to the lender, as well as certain absolutely can’t-have negatives that automatically disqualify a prospective borrower. The specific factors taken into consideration on a given loan will vary based upon the type of loan, purpose for the loan, term of the loan, etc. This analysis is not only done at the time of loan application, but also during the term of the loan as part of a monitoring process. This computerized process allows the lender to rapidly derive a score which is assigned to a loan request and taken into consideration by the loan officer, or loan committee, during the approval-rejection process.
Also, understanding that different lending institutions focus on different types of business loans and refuse to lend to certain specific industries is important, thus, knowing the culture of the lending institution is critical.
However, in the end analysis, the most important variable is always the individual borrower. If the borrower is not a person of good character and integrity there is little likelihood that they will receive a loan, no matter how strong their financial statements.