Securing capital from banks in the form of loans is one of the most tried and proven sources of capital. But, banks aren’t ideally suited to handle a good portion of business loan needs of our actual economy.
Contemplating lending criteria
When a bank or any type of lender talks of underwriting a loan, it means performing due diligence. It’s the same process used by private capital sources when they consider providing additional debt or equity financing for a business. The lender undertakes a detailed review of the loan applicant’s financial and business information to ensure that the borrower is worthy of a credit.
Here are five key principles a business must meet before a bank considers providing a loan:
• Business plan: To obtain a bank loan, your company needs a solid business plan with a highly experienced and credible management team. These requirements reassure the bank that its cash is being turned over to a third party who knows how to run a business and generate profits. A plan that doesn’t have this is sure to fail.
• Positive earnings: Usually a company must generate positive cash flow or earnings to secure a loan. Banks are cash-flow lenders, which means that for any type of debt they offer, business cash flows must be adequate to repay the debt. So if a company has historical losses or is forecasting losses in the future, the loan will not be obtained.
• Solid financial performance: The strength of a company’s balance sheet is just as important as positive earnings when a loan is requested. When a business has too much debt compared to too little equity, its business risks increase and a bank’s interest decreases. So if your business is too leveraged, you are not a good candidate for a loan.
• Sound collateral: Banks lend against assets to protect their loans. So every business looking to secure a bank loan needs to have sound collateral available (to repay the loan in case the business can’t).
Generally, banks like to lend against the most liquid assets, such as trade accounts receivable. They tend to be more cautious when asked to accept collateral such as inventory and equipment.
So a bank’s preference is to lend primarily against trade receivables and, if needed, then offer reduced loans or lending facilities against higher risk assets such as inventory.
• Secondary repayment: For most smaller- to medium-sized businesses (the mayority in America), banks generally look for a secondary source of repayment to ensure that the debt gets paid. If cash flow isn’t adequate and the collateral doesn’t cover the debt obligation, the bank needs to turn to another source of repayment to cover the debt.
This secondary source generally falls back on the personal assets of the company’s owners, which may range from real estate to personal savings to retirement accounts to other business interests owned.
A personal guarantee (or PG) pretty much means what it implies. That is, if your business can’t repay a loan, then the lender will pursue the assets of the individual who signed the PG to ensure that full payment is received. If you elect not to execute a PG, then the bank views your reluctance as a sign that you, the owner or founder, don’t have faith in the business.
So, even if all the other principles are met, why would a bank lend money if the owners aren’t willing to stand behind the Company?
Changes in lending policies
Since 2007, frustration with the banking industry, at both the personal and business levels, has been well documented and has reshaped the banking industry’s role in the capital markets.
Businesses are now being treated to a new normal that makes securing loans much more challenging. Banks still play a vital role in the capital markets, but businesses must clearly understand when a bank can provide debt-based capital and when it can’t.
if your business qualifies, then taking advantage of this source of debt capital is advantageous because it usually carries far lower fees and interest rates than other forms of debt-based capital.
However, if you fail to meet just one of the five criteria, then banks may lose interest, so it’s inecessary that businesses understand the alternative forms of debt-based capital available.
If you fail two or more of the criteria, then bank-financing options will likely be very scarce.