How smart banks evaluate risk when you’re seeking a loan
If you are thinking about approaching a bank for a loan, keep in mind that while the bank must analyze risk, they are also viewing you as a potential new customer.
Most banks still make the majority of their income from interest paid on loans, so their ability to grow depends largely on their ability to bring new borrowing customers into the bank. How they evaluate risk in your company can change depending on the type of loan you are looking for.
In the business banking world, loans are generally made to finance a mixture of business assets. Working capital lines of credit tend to rely on short-term assets, such as accounts receivable and inventory. Term loans are generally obtained to finance long-term assets, such as equipment and buildings. Regardless of the loan type, all banks will initially look at some key metrics found on the company’s balance sheet. Debt-to-equity ratio illustrates how leveraged the company is at the time of the loan request.
While there are some standard leverage ratio targets (2-to-1 for example), many industries have higher expected debt-to-equity ratios, often because they are more capital intensive. Another key ratio is the relationship between current assets and current liabilities. This ratio gives the bank a good indication of the company’s expected cash flow for the near term. This is important to determine how well the business will be able to serve its short-term obligations, such as loan payments and vendor payables.
In addition to some key ratios, banks are also interested in the level of equity in the company, its history of profitability, its plans for the future and the makeup of the management team. A well-capitalized business is better able to ride out tough times or periods where the business is losing money.
Consistent profitability is a sign that the management team has a good handle on expenses, product pricing, margins and back-room operations. A management team that has industry experience and has worked together for a number of years gives a bank additional confidence that the business will be able to anticipate changing trends in their industry and make intelligent, proactive decisions in response to most macroeconomic challenges.
Cash management a must
The most pressing concern for business owners is cash flow: do I have the money to meet weekly payroll obligations and make payments to key vendors to keep supply chains open? Monitoring the invoicing of new sales and the collection of accounts receivable is a daily function for most business owners. Obtaining a working capital line of credit from a bank can make managing a company’s cash flow much easier.
With a working capital line, banks provide a revolving line of credit based on the level of short-term assets on the company’s balance sheet. These assets are typically accounts receivable and inventory. Banks use a formula called a borrowing base to determine the credit line size. A good rule of thumb is to advance 80 percent on accounts receivable and 50 percent on inventory.
For example, a company with $300,000 in accounts receivable and $200,000 in inventory would likely seek a credit line of roughly $340,000.
There are many additional factors that banks look for when evaluating short-term assets. Accounts receivable over 90 days past due or due from foreign companies are typically not included in the borrowing base formula. Inventory is often excluded if it has become dated (has not been sold in over a year) or would be very difficult to sell in liquidation. The more commoditized the inventory, the higher advance rate in many cases.
Key benefits to using a working capital line of credit include:
Ready access to cash that would otherwise be tied up in receivables and inventory, cash that can be used to fund payroll or stay in current payment terms with key suppliers.
Flexibility when looking to purchase additional inventory to take advantage of supplier discounts or combat seasonality or delays in your revenue stream.
Accountability for the owner and CFO to not overextend the company. Staying within the borrowing base formula ensures the company is not growing too fast or taking on too much inventory at the wrong time.
Freedom so the management team can maximize the use of cash in the areas of the business where that cash will generate the best return.
All of these decisions and analysis, however, begin and end with the relationship between the business owner and the banker. Bankers realize that ultimately they are relying on the owner and the management team to run a growing and profitable business, to navigate changes in the industry and the economy and to keep the bank informed about how the company will meet all these challenges.
The ability of the management team to make good decisions is what dictates the company’s track record in paying loans and operating well into the future.