Tuesday, April 1, 2008

The 4 C's of Getting a Bank Loan

I think it would be worthwhile to cover the four C's of credit from the perspective of the start-up, emerging, and medium-sized company perspectives. Particularly, understanding the four C's from this perspective should help these businesses better understand the banker's perspective when trying to determine the credit worthiness of the company to which they may extend a loan.

The four C's are: character, capacity, capital, and conditions.

CHARACTER
Business owners sometimes struggle with this the most. The reason - we feel like the loan should be based on the character of the business ALONE. The reality - unless it is for a small amount, banks do not offer loans or lending based solely on the assets or free cash flow generated by the business. They always look to a secondary source of repayment, primarily in the form of a personal guarantee from anyone who owns at least 20% of the business. This means that banks will be looking at the character of the business as well as the character of the owners of the business in underwriting lending opportunities.

On the personal side, this means they will want to see your most recent three years of tax returns, including all K-1s you received and reported on those returns. This underlines a very important reason to get your taxes done on-time every year with a competent tax CPA. Bankers will become uncomfortable if you tell them you are behind on your returns for a couple of years, and they will become leery if they see blatant mistakes on your returns. Also, they will require a personal financial statement, which includes all of your sources of income and your current balance sheet (Assets = Liabilities + Net Worth). They will not begin the underwriting process without this information, so you should give it to them before they even have to ask for it. Nurturing the banking relationship in this way is often overlooked by business owners, so you can become one of the banks favorite customers, and receive better treatment and their best offer.

On the business side, be prepared to provide the company's most recent three years of tax returns and financial statements (along with the most recent interim financial statements) as well as a formal business plan and pro formas, or projections, of the plans for the business. Again, the tax returns should be correct and current for the reasons listed above. Also, the financial statements should match the tax returns. If they don't, then the bankers begin to worry about what is going on and they become less comfortable with putting a deal together. Your projections and business plan should include a pro forma income statement, balance sheet, and statement of cash flows. These projections should justify the use of the funds requested and clearly identify the firm's ability to repay the loan well within the timeline requested.

All of these items help the bank understand the character of the business and its principals. They will most likely run credit reports on the owners and the business, and they will search for liens, judgements, and any other information they can find. Both your and your company's character are paramount in a bank wanting to do business with you. A savvy business owner will set themselves up to put their best foot forward with their bank. We have found that we have been able to help businesses in this area, and our presence as the firm's part-time CFO has improved the company's ability to obtain financing. For example, we helped one of our clients increase their bank loans from under $750,000 to almost $5,000,000 in a very short period of time.

Do you know what your debt-to-equity ratio is? How about your current ratio? At what multiple is your interest coverage ratio? These and other ratios derived from your firm's financial statements help a bank determine how much money they are willing to lend you. In essence, the bank is going to assess the capacity that your company has for debt and how much they are willing to lend your business.

In the process of determining your company's borrowing capacity, the bank wants to know in what position they will be against your company's assets. If it is a small enough loan, they may be willing to offer an unsecured loan, meaning they have no claim on company or personal assets if you default. Or, the bank may want to secure, or collateralize, itself against some or all of your assets. Banks will usually file a UCC-1 lien on your business stating the assets to which they have rights should you default. Some business owners are offended that the bank would take such drastic preliminary measures. The bank has shareholders and federal regulators that they must appease - this is how their industry works.

The way a company accounts for its assets and liabilities can make a big difference in the bank's perspective of the company's capacity to borrow. It is very important that all of your loans are booked correctly, meaning the current portion (the next twelve months of payments) is separated from the long-term portion (all payments due later than 12 months) on your balance sheet. Inter-company transactions and shareholder loans need to be treated correctly or they can hurt the bank's view of your overall lending capacity.

CAPACITY
Do you know what your debt-to-equity ratio is? How about your current ratio? At what multiple is your interest coverage ratio? These and other ratios derived from your firm's financial statements help a bank determine how much money they are willing to lend you. In essence, the bank is going to assess the capacity that your company has for debt and how much they are willing to lend your business.

In the process of determining your company's borrowing capacity, the bank wants to know in what position they will be against your company's assets. If it is a small enough loan, they may be willing to offer an unsecured loan, meaning they have no claim on company or personal assets if you default. Or, the bank may want to secure, or collateralize, itself against some or all of your assets. Banks will usually file a UCC-1 lien on your business stating the assets to which they have rights should you default. Some business owners are offended that the bank would take such drastic preliminary measures. The bank has shareholders and federal regulators that they must appease - this is how their industry works.

The way a company accounts for its assets and liabilities can make a big difference in the bank's perspective of the company's capacity to borrow. It is very important that all of your loans are booked correctly, meaning the current portion (the next twelve months of payments) is separated from the long-term portion (all payments due later than 12 months) on your balance sheet. Inter-company transactions and shareholder loans need to be treated correctly or they can hurt the bank's view of your overall lending capacity.

CAPITAL
The bank wants validated proof that your company and the personal guarantors have the financial wherewithal to repay the loan. They will first look to the free cash flow the business has generated over each of the last three years. As a general rule of thumb, free cash flow calculates the amount of cash available for distribution to equity and debt holders. Generally, a firm's free cash flow is derived from the following formula: Net Income plus depreciation/amortization plus or minus the change in working capital minus capital expenditures.

Next, the bank will look at the equity, or net worth, in the company. First of all, they want to see a positive net worth. Second of all, they want to see that the net worth is increasing. If it is decreasing, they will jump to one of two conclusions - either the company is not profitable or the owners are taking too much money out of the company. I once sat in a meeting in which the banker accused my client of using the bank loan to distribute cash to all of the owners of the company. We were able to quickly help the banker understand what really happened, but therein lies the point - the bank has certain things for which it looks. Without the right information, the bank will make assumptions, whether the assumptions are correct or not.

A savvy borrower will understand this and head the bank off by anticipating its questions, in advance, and answering them voluntarily before the assumptions are made. The bank will next, somewhat hesitantly, look over your projections to understand if the cash flow trends may change in the next 12-24 months. Unless you have proven to them that you really understand your business and can make relatively accurate projections, they will put very little weight on the information in your projections. This is often a frustrating point for business owners - bankers loan money based on the past. Once the bank considers the capital in the business, it will next analyze the capital of the personal guarantors or collateral offered as a secondary source of repayment.

I have often seen a business receive financing based solely on the capital of the owners. I had a client once tell me that the bank was willing to loan him only as much money as he could write a check for and personally pay-off himself. While this is not entirely true, a strong personal financial statement of the owners brings a high degree of comfort to the bank.

CONDITIONS
What are the external factors that the bank considers in its underwriting process? Normally, the bank is concerned with shielding itself from risks that may be outside of the bank and the company's control - these are referred to as Conditions. Some of these external factors include the economic conditions of the geographic market and industry in which the company operates, political and/or legislative concerns, among other items.

Here is an extreme example - a bank of one of my client's refused to allow us to increase the company's line of credit because they felt the industry in which the company operated was headed for a major downturn. With a phenomenally strong balance sheet and enough work and orders on the books to justify a healthy and profitable rate of growth, the bank still refused to consider the request for an increase in the line of credit. The point is that banks are about hedging their risks. They are trying to avoid over-concentration, and they often make decisions based on big picture trends and concerns that have nothing to do with the attractiveness of an individual loan.

In the example above, we found three other banks more than willing to compete for this wonderful customer with a perfect credit history. The result - we doubled their line of credit into seven figures and got better pricing on the deal than we previously had.