Roots Run Deep
I find that no matter how much I'm involved in my business
, I am always drawn back to my banking roots. I've spent the past week talking to several prospects about loans and credit for their businesses. But then, savvy business owners seeking to conduct business with the federal government understand that credit and the ability to leverage are essential to successful performance on government contracts.
So, let's talk lending shall we. As you may know from following me, I spent over 20 years in banking. During the last 6 years of that, I worked exclusively with small business owners. In my time, I've extended a lot of credit to individuals and businesses and there is a common theme with those clients who've been approved - Credit, Collateral and Cash Flow.
You will often hear bankers talk about the "C's" of Credit, well, these are they. Credit, Collateral and Cash Flow: the foundation upon which any loan can be extended. Like any good foundation, the stronger it is, the bigger the building or, in our case, the loan. Sounds simple enough, right? Well, like all fundamental principles, it is simple, though it isn't always easy. The Law of Cause and Effect for instance, eat less and exercise more, you lose weight - simple, not always easy. The same holds with the Law of Credit. Truth be told, there is no universal Law of Credit, but if you are the borrower seeking credit, you want to know the rulebook the lenders are using, right? So let's talk about the first "C", Credit.
We have all heard of it, we know what it is, but what is good enough for a bank. The answer is going to frustrate you It depends. Depends on what you ask. Well, several things. Are you a client of the bank or a prospect of the bank where you are applying for credit?Have you been in business a while, or are you just starting out? What industry are you in? These all play into credit because each determines risk in one form or another. Let's use an example, if you are a client of your financial institution and have been in business for 6 years as an IT consultant, then your score can be lower than the same applicant who is a prospect. That same IT consultant, however, will likely need a higher score than anotherapplicant who is also a client and the owner of a CPA firm in business for 6 years. Why? The industry poses risk as well.
Certain industries are higher risk than others. As a rule of thumb, the more skill required to enter into your industry, the less risky. That isn't always true, but it is an easy way to think about it. Doctors, CPA's, dentists, attorneys, engineers or architects, for example, are all professionals who are required to have years of schooling, training and experience to get into practice.A few examples of higher risk industries and what makes them so are listed below:
Restaurants - how many vacant restaurants are in your neighborhood right now? Exactly
Trucking - relatively low cost to get in ($8-10K for a used truck) and limited skill is needed
Construction - new home construction from 2008 - 2010, need I say more
This isn't to say that a business that's high risk can't get a loan (I've done a restaurant startup before, talk about your high risk) but understand that the foundation I spoke of earlier must be solid as a rock. The bottom line is your score needs to be in the high 600's MINIMUM, preferably 720 or better. That number can be a challenge, but it is not an impossibility. Ok, so now you understand the credit piece, onto the next "C", Collateral.
With collateral, the financial institution gets a comfort level that they have something to liquidate if you don't repay. Banks can use all kinds of things as collateral, but the most common are Accounts Receivable, Equipment, Inventory, Real Estate, Stocks or Brokerage accounts and cash. Oftentimes banks will take a blanket lien on "all business assets" via a UCC filing.One thing to remember is this, banks are not collateral lenders, banks are cash flow lenders. So even if you've got lots of collateral, if the loan can't cash flow, it usually won't be approved. So let's talk cash flow.
In today's world especially, Cash Flow is King. Without cash flow, the loan will NOT work. Most business owners think of cash flow in terms of the "top line" or the money they run through the bank. But lenders are looking at the "bottom line". It's great that your business did $3MM in sales, but if the net profit was ($100,000) then things aren't so hot. Interest and depreciation can usually be added to the net income but oftentimes those write-offs aren't big enough to turn a large net loss into a positive number.
Generally banks want to see a cash flow ratio of somewhere between 1 and 1.5, depending on how conservative the institution. That just means $1.00 of cash for every $1.00 of debt (1 to 1) or $1.50 in cash for every $1.00. Again, cash flow is King so the higher the Cash Flow Ratio, the better. The cash flow ratio is calculated not as debt to income on a monthly basis, as in the case of a mortgage, but as income to debt on an annualized basis. Let look at some simple examples.
$100,000 annualized income / $75,000 annualized debt payments = 1.33 cash flow ratio
Or
$85,000 annualized income / $75,000 annualized debt payments = 1.13 cash flow ratio
Or
$50,000 annualized income / $75,000 annualized debt payments = .67 cash flow ratio
Again, this is very simplistic and there are factors to calculating the annualized income that each bank will tweak but at least you have an understanding of how to calculate the ratio.
Like I said before, simple but not always easy. Another thing to remember is that strength in one area can mitigate a weakness in another. So a lower credit score can sometimes be overlooked if the cash flow is really strong. A shortage in collateral may be overridden with strength in cash flow. Keep in mind, however, that there is no way to mitigate a shortage in cash flow. If there isn't cash coming in to pay the current and proposed debt, the loan won't work.
I hope this information proves useful and gives you a bit of insight into what goes on behind the curtain. As I mentioned at the onset, my banking roots run deep so if you have specific questions, I'm more than happy to answer them for you as well. Now, go forth and borrow.
by: Myra Cisse
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