Question: I'm going to need some bank financing to expand my business pretty soon. I know banks have certain standards for sizing me up as a potential borrower. What are those standards and what else do I need to know?
Answer: Yes, your commercial banker will be looking at how you fit their lending criteria. There are no big secrets in what they're looking for, but there are some recent developments you should be aware of. Let's talk about this.
Today we'll cover some basics of business lending and credit analysis. Along the way we'll look at some banking terms that may be new to you.
You mentioned expanding your business, which suggests that you have at least a few years with a successful track record. That is a strong plus in your favor.
You may have heard of the "Five Cs of Credit." The concept has been around for years. Of course, like most things about business, the Five Cs have evolved. And, the current business slowdown has brought in a few new wrinkles. Basically, here are five factors a banker will evaluate in looking at you as a potential business borrower.
Character. This dimension is a little more subjective than the other four, but it's critical. It's about you personally. Are you experienced and established in this business? How is your reputation? Do you contribute to the community? If your business ran into a rough patch, would you hang in and see it through?
Avoid a common mistake: Never tell a banker that there's additional income that's not reflected on your tax returns (wink wink). If you'd lie to the government and expose yourself to possible criminal penalties, the bank will definitely not be interested in dealing with you. Consider one of my favorite quotations (U.S. Sen. Alan Simpson): "If you have integrity, nothing else matters. If you don't have integrity, nothing else matters."
Capital. This is the "skin in the game" factor. What is your personal financial investment in the business? Bankers look at your leverage ratio - they call it "debt to equity." It typically should be less than three to one. This means you have a personal dollar invested for each three dollars of loan funds. It's very helpful if you can show a record of keeping some profits in the company as equity, or "retained earnings" if a corporation.
Your last two or three years' financial statements will get heavy scrutiny. Note that this is an excellent reason to get some professional accounting help well before you expect to seek financing.
Capacity. Here, the bank will be assessing your ability to repay the loan. Factors include your borrowing history and repayment record. A major focus will be a "projected cash flow analysis," to establish that you can meet the repayment schedule. You'll also hear the term "debt service coverage," which is one of several ratios and metrics the banker will analyze. It's common for the bank to want available cash flow to be 1.2, or recently 1.3, times what the monthly note payment will be. This allows a cushion for a weak month in sales or collections.
Conditions. This catch-all category looks to the other factors surrounding the proposed loan. A major consideration is the purpose of the loan (the "use of funds"). For example, a loan or credit line for beefing up a seasonal inventory is a completely different animal from a loan to buy a large piece of long-lived equipment.
Also of interest is how your business is positioned in your field. Is your industry growing? Are your sales growing? Is that likely to continue? Will you remain competitive going forward? Is your staff well-trained and stable? Are you following a written business plan?
Collateral. Notice that this is last on the list of the five Cs. Understand that banks and businesspeople view this issue completely differently. To the business owner, it's "I can't understand why they want me to put up everything I own to cover this loan." What that misses is that the bank emphatically does not want to repossess your collateral. They want to make a reasonable loan, which you can and will successfully repay.
To the bank, it's "Is this borrower serious or not?" For a good-size loan, if you're not willing to go "all in," you won't be taken seriously. This will include a personal guarantee if your business is a corporation or LLC.
Last, if your business is very small or a start-up, the lending guidelines are somewhat different. We'll talk about that in a future column.
Ask SCORE is prepared for The Bellingham Herald's Sunday Business section by Bob Dahms, a business counselor with the Bellingham chapter of SCORE. Submit questions for this column to Business Editor Dave Gallagher at email@example.com. To learn more about other small-business matters, contact the local SCORE chapter at 360-685-4259 to schedule an appointment. For details about the organization, visit SCORE.org.