Your business is growing quickly and you are approaching the next step on the growth stairway. This step includes the risk of taking on more debt to grow your company.
What is the best way to look for funds?
Be they a credit union, bank or private equity lender, a financial partner supplies the financing and serves as an objective resource for you. With a potential lender, one of the first hurdles you’ll face is how they use your financial information.
Your banker is not speaking the same language as your accountant.
Accounting is the “language of business” but the role of a banker is different. Bankers use the financial statements and CPA’s prepare them. These roles are very different. One is primarily designed to make decisions based on the information. The other is applying principles to the preparation of the statements.
All this doesn’t mean squat to you. You just need a loan.
To understand how to get a loan, you must speak the language of a banker; give them what they want. Since the terms between accounting and banking sound similar, or at times identical, it can be confusing to start a conversation with a banker.
Before you think all banking is about money, remember there are 5 “Cs” in banking and most aren’t financially related.
The five C’s are:
- Character – The borrower’s general trustworthiness and credibility
- Capacity – The ability of the borrower to manage their business
- Capital – How much skin the borrower has in the project and available outside the loan
- Conditions – The overall economic conditions in which they are operating
- Collateral – Assets are you going to “trade” with the bank for the loan
While there will be a debate about which one is most important of these five, the loan vetting process will include an analysis of all five.
Banking is a highly regulated industry
The government is heavily involved in loans banks make to borrowers. Every year, banks have their loans reviewed by examiners to regulate whether the bank acted with a prudent or predatory nature. It’s safe to assume that every loan made by a bank is being watched by the government so you need to give the bank (and the government) what they want.
Despite that, the primary motivation of a banker is to lend bank capital to a borrower who can invest in a business that is mutually beneficial. A banker doesn’t want the collateral of the borrower, he or she just wants their principal back with a little interest. You could say they are in the business of renting money.
The five C’s above are designed to shed light on the aspects of the borrower seeking a loan and also give the bank a context for lending. This due diligence is also helpful to ward off the examiners questions- it’s all being documented.
A perfect loan is one that doesn’t keep the banker or borrower up at night worrying how it will be repaid.
The interest rate and fees adequately reflect the risk incurred by the lender in the context of the economic environment. And of course, it is designed to give the company a shot in the arm so they can accomplish their growth hurdle.
When preparing a loan, the bank will need to see the recent few years’ history (oftentimes three years) to see the profitability.
They will pay attention to the revenue and profit growth or decline and compare it to other clients in the same industry. If you are working with an experienced banker, s/he will already know the challenges the industry has faced and have several other clients in your field.
Tip #1: Spend time explaining downturns and special one-time events that transpired in your company. If you are preparing a writeup for the bank, walk them through the key factors impacting the business and explain any abnormal variations.
Of the most important items to a banker, cash flow may be the biggest. Cash flow is how the cash makes its way through the company. This is the biggest difference between the preparer of the financial statements and the banker. The banker is more concerned that the borrower has the cash to pay the loan while the preparer is oftentimes attempting to minimize taxes.
There are certain non-cash expenses CPAs use to reduce taxes which have no impact on cash, depreciation being the most popular of these. Depreciation reduces taxes for the business but doesn’t require cash. The banker will disregard depreciation entirely to determine cash flow.
This is where the banker will calculate the debt service coverage ratio to see how your loan has been performing. There are bank policies for coverage ratios. If you know these, you can calculate your numbers to know where you stand before requesting funding.
Tip #2: Show the banker how you will be able to cover the loan payment with cash from the business by calculating the expected coverage ratio after the loan.
Collateral is what you are offering (“trading”) to the bank in return for the loan. Rarely are loans made without collateral because of the risk. When you are selecting collateral for a loan, the easier the bank will be able to sell the collateral, the better the collateral. The better the collateral, the better rate or terms you get.
Once you select what you want to offer for your loan, remember the bank won’t give you 100% of the value of your collateral for the loan. Just as the popular pawn store television shows, the bank will lend you money based on a percentage of the value of the asset. Different collateral receives different percentages.
Tip #3: The percentage a bank will give on an asset will vary by bank. Ask the banker what the bank’s policies are as you research your partner.
A healthy business maintains a balance between what it owns and what it owes. Owing too much risks “sinking the ship” and ruining the business or incentivizing the owner to leave the partnership. Bankers track this through the debt to asset or debt to equity ratios. This represents, in numerical terms, the amount of risk that the business will be unable to pay its debt. Again, the bank will have a policy on their ability to lend to a company. Exceeding this level jeopardizes the ability of the bank to make new loans.
Tip #4: Know your leverage ratios for before and after the loan you are requesting. Leave wiggle room for additional loans should opportunities present themselves.
The ideal financial partner for your business is someone who will grow with you. In the same way you evaluated the character traits of your spouse, spend time evaluating the character of the banker and bank you are looking to partner with. Know your numbers and talk the same language as the banker for best results.
While business is ultimately about people doing business with people, it is often framed in the context of numbers. Choosing a financial partner should be about more than numbers. Be sure you like working with the lender or representative if you expect to have a long and profitable relationship. A great financial partner can make the future of the company.