What bankers want to know before granting a small business loan.
CPAs can help an emerging company secure bank financing by gathering data to support a written loan proposal. The profound changes that have marked the banking industry during the past several years have been a mixed blessing for small companies. On the positive side, small business loans have become more available as an increasing number of community banks--the traditional source of small business financing--have been absorbed into regional or urban banks. These larger institutions have been courting small and midsized companies aggressively.
Still, the widespread demise of the community bank has forced many smaller companies to rethink their banking relationships. Larger banking institutions are, as a rule, much less personal and informal than their community bank counterparts. Because assignments for branch officers at large banking institutions change rapidly, the once common long-term relationship that often existed between small business owner and banker is disappearing rapidly.
HOW TO KEEP A BANKER INFORMED
The less a banker knows about a company, the more information the owner must supply to present a convincing case for receiving a loan. For that reason, the best time for a small business owner to get to know his or her banker is before a loan is needed. He should treat his banker much as he does his important customers and suppliers. He could, for instance, take the banker on a tour of the company's facilities. He should keep the banker routinely informed of progress, through personal contacts and interim reports in which both problems and strengths are discussed.
Once the banker becomes familiar with the company, he can understand its needs. Then it is easier for the owner to explain the reasons for a loan request. Most important, the direct contact will enable the banker to be knowledgeable when he presents arguments for the loan to the loan committee. Even if the banker is transferred, the relationship can still pay dividends. As one regional banker noted, "I keep extensive files and notes on all my contacts with prospective customers. If I move on, the file stays here for my successor to use."
PREPARE A LOAN PROPOSAL
When a loan is needed, the most effective way to justify it is through a written loan proposal, a device used routinely by large corporations. A thoughtful loan proposal prepared in cooperation with a CPA will present the business owner's case at the first loan interview. It will document how the funds will be used and, more important, how and why the plan for repayment will work.
WHAT THE BANKER NEEDS TO KNOW FIRST
There are five questions a banker wants answered "as soon as the customer walks in the door," as one loan officer put it. These should be answered in the loan request, which is always the first section of a loan proposal. They are:
1. How much? Tell precisely how much money is needed. A rounded figure or a range suggests the owner has not done enough homework.
2. What purpose? Again, the banker expects a specific, comprehensive answer. A vague description, such as "for general corporate purposes" will not suffice.
3. How long? How quickly does the company intend to pay back the funds?
4. How will the company repay? Be prepared to supply documentation. If, as in most cases, repayment will be from cash flow, the CPA should provide either cash flow or receipts and disbursements projections for at least the life of the loan.
5. What if something goes wrong? Here, the banker is looking for an ace in the hole--an emergency plan if the loan doesn't work out. It could be a plan to sell an asset, borrow elsewhere or bring in a new investor. Whatever the solution, a sound emergency plan is an important ingredient of any loan proposal.
ADDITIONAL LOAN PROPOSAL INGREDIENTS
Although the loan request is by far the most important section of the loan proposal, it must be supported by background information that will give the loan officer enough ammunition to justify the loan before the loan committee. Thus, each proposal must be tailored to suit the company it describes. However, the vast majority of proposals include all or most of the following sections:
* Company history. Describe the company and its business and summarize the important events in its history. If warranted, an organization chart and top management resumes can be included.
* Market evaluation. Discuss the company's principal markets, with emphasis on their stability or lack of it. The section also should describe strategies the company uses or plans to use to deal with problems. It should comment on major suppliers, customers and competitors, if they exert an important influence on the company's marketing outlook.
* Product information. Discuss the company's principal products or services and any proprietary edge it may have in bringing them to market.
The banker's interpretation of the company's financial statements that accompany the loan proposal is crucial to its success, and a CPA may be able to supply additional information that will place the statements in a more favorable light. For instance, if the small business uses a compilation, the CPA could assist management in drafting footnotes to tailor it for use by the bank. Alternatively, the CPA might assist management in summarizing the reasons unusual numbers appear as they do, whether they are favorable or unfavorable. Or additional supplemental schedules could be compiled to explain a particularly complex transaction.
Bankers normally request the following financial statements with a loan proposal:
* Annual balance sheets and income statements for the past three years.
* Most recent interim balance sheet and income statement.
* Current personal financial statement.
* Tax returns (corporate or personal) for the past three years.
* Income and cash flow projections for the next three years.
* Recent aging schedules for receivables and payables.
* Recent real estate and equipment appraisals.
HOW A BANKER LOOKS AT A COMPANY
For generations, bankers have turned to the "six Cs" to evaluate borrowers. These are still in widespread use as an evaluation tool. Note how the aspects of a loan proposal already discussed cover most of the components in today's version of the six Cs.
* Capital. Has the owner committed a significant amount of his own money to the business? A balance sheet will indicate this.
* Coverage. Is there enough cash flow to cover debt service? Cash flow statements will give clear evidence.
* Capacity. Will the capability of the company to generate cash flow improve in the future or does the product line have limited growth potential? Cash flow statements and the product information section of the loan proposal should provide answers.
* Circumstances. Is the company in control of its own destiny, or is it dependent on one or two customers or suppliers? Can the company survive a business downturn or a financial crisis? The market evaluation section should give some insights.
* Collateral. What is the value of the assets that will be used as collateral in case of problems? The recent appraisals of real estate and equipment will give a definite indication of value.
* Character. Unlike the first five, the final C deals with an intangible quality, but one most bankers insist is at least as important as the company's finances. One loan officer says, "I get paid for sizing up character and basing my judgment on whether or not to grant a loan on that assessment. If I'm wrong, and the loan is granted, there's no way we can keep a crooked borrower from taking some of our money before he's caught." Thus, bankers look for evidence the owner is honest. This includes a commitment to the company's success and a willingness to put in the time and effort necessary to keep it growing. They also want to be assured the owner is determined to repay the loan on time. Other key qualities bankers use in assessing honesty include a good industry track record and a demonstrated ability to earn money in a variety of circumstances.
BANKERS' PET PEEVES WITH SMALL BUSINESS LOANS
Bankers are in almost unanimous agreement that submitting a hurried request for funds is the most frequent mistake made by small business owners applying for a loan. In the absence of a natural disaster or an act of God, a request for an emergency loan is a sure sign of poor planning. In the banker's view, a competent manager would never allow a cash need that should have been anticipated to approach the crisis stage.
Small business borrowers can improve their chances of approval significantly by anticipating their cash needs well in advance and allowing the bank adequate processing time. The lead time varies, depending on the bank's procedures and the loan backlog when the application is submitted. However, borrowers should allow a minimum of three weeks for processing.
Poor preparation is the second most frequent small business mistake. Most bankers are surprised at a lack of preparation, since the information requested is, for the most part, standard throughout the industry and easily obtainable. Obviously, a properly prepared loan proposal will contain all of the necessary information.
Other negotiating practices that raise a red flag include a less than candid attitude on the part of the borrower and a preoccupation with the company's growth potential. Since the bank is a lender, not an investor, it is more concerned with cash flow than with profits. Indeed, many banks become leery when told an owner intends to become a millionaire using the bank's money. Few small companies are equipped to handle such rapid growth.
In addition, the borrower should forewarn the banker at the outset about any skeletons in his closet. If they turn up in the course of a loan investigation without having been mentioned earlier, the application is in trouble.
WHAT TO DO WHEN THE BANK SAYS NO
Even though most small business owners have been turned down for a business loan at least once in their careers, it is still a wrenching experience. But, instead of yielding to panic, an owner should make a concerted effort to find out the reason for the refusal. He can't correct the situation until he finds out what is wrong. Most loans are turned down for the following reasons:
* Poor communication. For some reason, the borrower and the loan officer can't get along. Under such circumstances, the chances for approval are slim. The borrower should ask the branch manager to assign him to another loan officer, who may be more understanding of the company's problems.
* Rapid expansion. Banks tend to back away from a company with revenues that are increasing too rapidly for its equity base. Be certain the loan proposal includes a detailed description of how the company's financial underpinnings will keep pace with sales growth.
* Overly optimistic loan proposal. If the forecasts in the loan proposal exceed industry projections without a satisfactory explanation, the loan may be turned down. Keep forecasts realistic, even conservative.
* Past misuse of loan funds. If loan funds are used for a project other than those mentioned in the loan proposal and the bank finds out, it will be difficult to obtain another loan from that bank. Whenever circumstances make it impossible to fulfill loan conditions, the bank should be informed.
* Rapid inventory buildup. To a bank, a sudden surge in inventories means either poor planning or an unanticipated drop in sales. In either case, granting new credit is risky. Make sure inventories are in reasonable shape before you apply for a loan.
BORROWING ON A COMPANY'S ASSETS
Small businesses can now use assets as collateral for business loans, from both banks and commercial finance companies. Commercial finance company lending standards are more liberal than those of most banks, but their interest rates are higher. Depending on the type of collateral, section of the country and duration of the loan, commercial finance company rates can run from 2% to 6% above prime for loans up to 15 years. Here's how the more common asset loans work:
* Accounts receivable loans. Available from either banks or commercial finance companies, you borrow 70% to 80% of the value of eligible receivables. Usually, an eligible receivable is defined as one that is from a creditworthy customer and is less than 60 days old. As checks in payment for receivables come in, the company fowards them to the lender, which deducts the interest and deposits the balance in the company's account. Interest is paid only on the outstanding balance. Rates vary with bank credit policies, but you should figure on 1/2% to 1% over a company's normal bank borrowing rate and another 1% to 2% at a commercial finance company.
* Inventory loans. Few banks will make an inventory loan because of the volatility of commodity markets. The loan is on a certain percentage of eligible inventories, defined as those for which there is a market. Freely traded commodities receive the most generous appraisals, while work-in-progress inventories receive the lowest because they are difficult to sell. Inventories are always valued at "knockdown," or distress, prices, and companies usually receive no more than 25% to 50% of eligible inventories. Rates are dependent on the risk factor but usually fall within 2% to 6% above prime.
* Equipment loans. Again, these almost always are negotiated through commercial finance companies. Here, a company finances new equipment by borrowing against old equipment. Machinery, rolling stock and computers can be pledged. However, the collateral must have a firm resale value, so obsolete, rare or unusual equipment is out. The equipment is appraised by an independent third party and the details of the loan are arranged. The terms depend principally on the useful life of the equipment and the borrower's credit rating.
HELPING CLIENTS RAISE CASH
Most small business owners are too busy managing their companies to pay close attention to developments in capital markets. Therefore, they may not be fully aware of the profound changes that have taken place in the banking industry's attitude toward small companies. By showing them how to operate most effectively under the new conditions, CPAs can not only provide a short-term service to their small business clients but also improve their chances for longterm success.
GENE R. BARRETT is a news editor of the journal. Mr. Gene R. Barrett is an employee of the American Institute of CPAs. His views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.
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|Author:||Barrett, Gene R.|
|Publication:||Journal of Accountancy|
|Date:||Apr 1, 1990|
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