Securing Capital from Banks - dummies

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

Looking to secure capital from banks in the form of loans is one of the most tried and proven sources of capital. The old (and possibly outdated) image of a business looking to grow and in need of a loan to expand, hire new employees, and increase sales and profitability has always been a mantra of the banks.

Sorry to spoil the party, but due to the criteria they use to underwrite the loan, banks aren’t ideally suited to handle a good portion of business loan needs in today’s economy.

When a bank or any type of lender refers to 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 creditworthy.

Mulling over lending criteria

Banks provide an important source of debt-based capital to businesses. Here are five key criteria a business must meet before a bank considers providing a loan:

  • Positive earnings: In most cases, 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, strike one.

  • 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 (which can become obsolete quickly) and equipment (which will depreciate in value and is expensive to liquidate if needed).

    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. If you don’t have quality collateral or the right collateral, strike two.

  • Solid financial performance: The strength of a company’s balance sheet is just as important as positive earnings when requesting a loan. When a business has excessive leverage (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, strike three.

  • Secondary repayment: For most smaller- to medium-sized businesses (the vast majority operating in America), banks generally look for a secondary source of repayment to ensure that the debt gets paid. Or in other words, if cash flow isn’t adequate and the collateral (if liquidated) 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. If no secondary repayment sources are available, strike four.

    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.

    Needless to say, PGs should be executed with the utmost caution and understanding, but at the same time, keep this important concept in mind: 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 why would a bank lend money if the owners aren’t willing to stand behind the company (even if all the other criteria are met)?

  • Business plan: To get 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. Any plan that a bank reviews that’s short on these items will certainly lead to strike five.

How lending policies have changed

Since 2007, nearly every bank has been maligned, fairly or not. The 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.

For example, prior to 2007, a bank may have been able to bend a little when extending credit to a good business that had some flaws (such as a relatively high debt-to-equity ratio).

However, 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 meets the five criteria outlined in the previous section, then approaching a bank is appropriate. Banks are always looking for A/A+ deals, and 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 imperative that businesses understand the alternative forms of debt-based capital available. And if you fail two or more of the criteria, then bank-financing options will likely be very limited.