A client recently asked if I would share a few thoughts on what a bank really looks for in approving loans and determining rates & terms. Those of us in banking often assume that everyone knows these things and we need to do a better job as an industry of helping our clients in this area. Here are THE top factors, which are collectively known as the 5 C’s of Credit (because they all start with “C”):
Character – Self explanatory. If you have trouble maintaining strength of character none of the other factors matter. We were considering a loan in the summer of 2011 that was very strong from every angle, except one — character of the borrower. This was someone used to getting their way and responded very poorly (threatening, yelling) to one of the terms we requested. The borrower tested the market and realized that this request was standard across all banks. They came back to us offering a sincere apology after realizing our overall terms were very reasonable compared with other bank’s offers but we were chose not move forward with the loan. If this borrower made threats early in the process what could we expect after the loan was extended?
Capacity – This is excess cash flow after expenses. The better the cash flow, the better the chance the loan will be approved. Cash flow is different from profit. Profit is an accounting concept and doesn’t have much influence on a loan approval. One simple way to think of profit vs. cash flow is this — you can’t take profit to the store to buy milk & bread but they do accept cash. Going more deeply into profit vs. cash flow is beyond the scope of this post but I’ll provide one VERY simplified example that may shed some light. A company that has low profitability may still be a good borrowing candidate if they have significant non-cash items on the income statement such as depreciation. If the company shows a net-loss (negative profit) of $100,000 but has $1 million of depreciation then they have $900,000 of positive cash flow. This example assumes depreciation is the only non-cash item for this company but there are many other factors besides depreciation that can negatively or positively affect cash flow.
Capital – This is another term for Net Worth, which is determined by subtracting liabilities from assets. Assets are what you own and liabilities are what you owe. The more capital a company has, the more evidence that there is a commitment to the business. Lower capital indicates that the owners have taken too much out of the company leaving it without a firm financial foundation.
Collateral – Collateral represents one or more assets offered as security for a loan. If a loan is not handled as agreed, the bank will convert these assets to cash to pay off the loan. The more easily the collateral is convertible into cash, the more value it has as collateral. Two examples:
- “Liquid” assets such as a publicly-traded stock portfolio can be quickly converted to cash to repay the loan.
- An art collection is not as attractive as collateral because the bank has to find & take ownership of the art first and then find buyers. Certain items of art are only valuable to certain individuals so selling art may not be an expedient process.
Conditions – Conditions represent the overall environment in which the borrower is operating. If the company recently lost their top three sales people, there may be questions about the future viability of revenues. Conversely, the bank may be comforted if it sees evidence of employee stability, strong demand for the company’s products/services, and recent successful cost-cutting measures.
In addition to the thoughts offered above, it is also a good idea to communicate frequently with your banker instead of waiting until the annual renewal of your line of credit. Here are some ideas:
- Include the bank on periodic press releases
- Ask you banker to lunch every few months. They should ask you but take the lead if they don’t.
- Send quarterly financial statements even if not required in the loan agreement
- Proactively communicate material events in the life of your company — especially negative events. It is better to mange those communications than have the issues discovered in the loan renewal process.
- Send your banker quality referrals from time to time (you should expect the same from them). This is a factor that is definitely considered in a favorable light. The bank is in business to make a profit and if your referrals help the bank then your loan request may be considered more favorably. The difference will not likely be seen in the approval of the loan (a bad loan request will not be approved no matter how many referrals the bank receives) but instead in more favorable terms.
I hope that helps and would be glad to answer any clarifying questions. Happy borrowing!