By Patrick McCarthy
For the Oregon Beer Growler
No matter where you bank, the process and fundamentals of obtaining a loan are almost universal. You fill out the application completely; supply all tax returns, financial statement and budget; and answer questions while a commercial banker encourages you to keep the information coming in as fast as possible. Then comes a credit denial — or worse yet, a long silence eventually followed by credit denial.
You’re thinking “Gosh, the banker seemed so positive and eager, so what happened? What a colossal waste of time!”
If this has happened to you or you want to avoid that scenario, a little insight into the process will assist with future commercial bank interactions.
First, it’s helpful to understand most bankers. He or she is compensated in part, or in whole, to develop business opportunities for his or her employer. These individuals network, make cold calls, ask for introductions and generally try to generate as much loan application volume as possible. They may not have in-depth credit analysis or training, but they sure know how to make new friends! The business development types are often loath to say much of anything negative about your loan approval prospects because they want to “give it a shot.”
Giving it a shot means your loan package is sent to an underwriter or credit officer. These are the people (or increasingly software algorithms) who work on smaller loans underwriting the risk and review for approval or denial. You will rarely meet one of these decision makers. That’s because most banks separate the business development efforts from the credit decision makers.
The credit-focused folks crunch numbers and assess your financial information through quantitative tests. Credit personnel enforce the bank’s credit policy, which means they hold authority. Therefore, your business development friend, while an important resource, is more of an accommodator trying to make both sides happy with the outcome.
Secondly, how do the number crunchers review your financial information? Since commercial banks are heavily regulated, commercial loans are largely assessed much the same way by every institution.
Number 1 – Historical cash flow is paramount! We bankers refer to cash flow as the primary source of repayment. Does the business generate sufficient historical cash flow to: a) cover operating costs, b) compensate the business owners and c) service the principal and interest on existing and proposed debt?
Seems simple, right? We bankers use a fancy formula to do this math:
Net Income + Depreciation/Amortization + Interest Expense + Taxes + Rents DIVIDED BY: Principal and Interest paid + Rents + Dividends + Distributions.
This ratio usually has to be equal or greater to 1.25:1. Usually calculated on an annual basis, the principal and interest on the new, requested loan are added in as well. If your business has consistently achieved this 1.25:1 ratio, you’re looking great!
Number 2 – Collateral is the secondary source of repayment. Remember when you obtained your first car loan? Which party had the pink slip? What would happen if the lender stopped receiving monthly payments? Yes, repossession/conversion of collateral was the secondary source of repayment. Credit-focused professionals will review the abundance and quality of your business’s assets to assess the viability of a secondary source of repayment. Brewers know their brewhouse and cellar tanks currently hold their value quite well, so the credit team should give you kudos for this “hard” collateral.
But you also trenched the floors, added a larger water supply and built a killer back bar. Those are assets too, right? Yes, but are they salable? Have a broad market appeal? Hold their value? Bankers typically characterize these assets as “soft” collateral.
Number 3 – Guarantors. Usually any individual or entity that owns 20 percent or more of the business are viewed as the third or tertiary source of repayment. The credit team determines the financial strength and credit history of each guarantor. Do the guarantors have resources outside of the business to help plug a problem or solve a financial hiccup? Do they have a clear credit history?
In summary, assessing these fundamentals are part of almost every commercial bank loan assessment. There are exceptions, of course, but as a loan applicant be aware and prepared to discuss these things with your banker next time you seek a loan. If you do, pursuing a commercial loan from a bank will be much less mysterious!
Patrick McCarthy is vice president and commercial relationship manager at Scott Valley Bank. He devotes much of his work day to craft beverage and food companies in Northwest Oregon. He can be reached at 503-208-3181 or firstname.lastname@example.org.