In the literal sense, every business is ‘bankable,’ but understanding what a bank is looking for from business owners is crucial for the relationship to be successful for both participants. Knowing what it means to be ‘bankable’ will help navigate the waters of applying for a loan and serve as a useful tool in preparing for what the banker is really evaluating to conclude ‘yes’ or ‘no.’ For example, simply increasing revenue year-over-year doesn’t necessarily mean a business will get approved for financing, which can be shocking and confusing.
A bank is just like any other company – they want to see a profit in doing business together, just as any business owner would with its customers. Consequently, the more one understands how banks profit and the risk they take in financing a company, the better one can negotiate with them.
The five C’s of credit serve as the basic model that most banks use: Character, Capacity, Collateral, Capital and Conditions. A banker will review all of these alongside one’s business model, so it is critical to understand the importance of each.
1.) Character is one of the most difficult to articulate, because everyone has his or her own definition. Some banks may simply look at a credit score to determine one’s character, while others are looking at references in the community their behalf. Get a clear understanding of how far the bank is looking into this one, as it may make sense to provide references up front if necessary.
2.) Capacity, along with character, is arguably one of the most important from this list. Capacity means cash flow, or the ability to repay the loan. Key data to have on hand, include: cash flow coverage ratio, fixed charge coverage ratio, and EBITDA (earnings before interest, taxes, depreciation, amortization) to debt payments. Keep in mind, that the banker will be operating under the general and logical premise that the business should be generating at least $1 in cash sufficient to service each $1 in debt. Most will want to see consistency for two to three years. Business owners will also need to know their personal debt to income (DTI) ratio. From a banking perspective, high personal DTI may throw up a red flag as it pertains to spending habits, so track this carefully.
Your business in particular, may have some seasonality in which the business loses money for eight months out of the year, but makes very good money for the other four, making it very profitable in the end. If you are showing your banker interim financial statements because the need for money has arisen now, make sure you demonstrate this seasonality to clear any confusion. Perhaps showing a month by month break out of your income statement or projections, including how things looked last year at the low point in the season and how things turned out for the year, will help you prove your case.
3.) Collateral is what banks fall back on when there are impairments to cash flow (capacity). But the reliance on collateral is where the debate comes into play. Some may wonder why the bank wants to see income for an extended period of time, if you have ample collateral. No question – collateral is a must, but the bank will have to take full responsibility of selling the collateral if the business gets into trouble and they have to take over. The bank will have to hire someone to sell it, which will take a cut into the sale, along with the stigma that goes with selling assets labeled ‘bank owned.’ One generally has to have some form of collateral to be ‘bankable’ but if a business is losing money, the strength of collateral alone will not make it ‘bankable.’
4.) Capital tends to cause the most confusion. The essential question is: what percentage of assets does the business actually own when the dust settles and all liabilities are paid off? It is not unusual to find a business or business owner who distributes all earnings from the company leaving very little strength to the balance sheet. The more money you leave into the company, the more the bank knows you have just as much to lose as they do. The bank does not want to be the only player with ‘skin in the game’ and will want to know that the company is committed as well.
If your capital base is low, your banker may ask about “off balance sheet equity.” Off balance sheet equity includes equipment or real estate that was bought years ago. It may be fully depreciated, but I would recommend getting an appraisal on these assets to show true market value. It’s another way you can give your banker a clearer picture of your assets.
On the flip side, the value of your company is generally not something that will help you state your case when it comes to the “capital” conversation with a banker. Many times I will hear business owners talking about some multiple of their EBITDA, or enterprise value. Remember, depending on your line of work, your business or enterprise is only valuable under the premise that it operates as a “going concern.” Your cash flow stream or customer lists or proprietary products will likely have no merit in a banker’s eyes who is viewing capital at its very core, which is: “what are your assets worth (generally at cost) and how much debt do you have against your assets vs. liabilities.”
Lastly, in many cases, a personal guaranty is discussed with business owners, but remember, the company is often viewed as its own identity and the primary source of repayment. While you may view your personal guaranty and personal assets as an extension of the company, your bank may think differently.
5.) Conditions refers to the economic climate. During the 2008 downturn, some business owners saw their covenants or loan terms change even with their company doing well. This was an outcome of the economic climate. In conversations about financing, business owners should know how their industry is performing as a whole, not just their company specifically. They should also be aware of the broader economic environment.
The five C’s are an excellent guide to learning how to be a ‘bankable’ customer, and how business owners can lead a conversation with their banker about obtaining competitive financing.
Sean Nohavec is senior vice president of business development at UMB Bank in Colorado. He can be reached at Sean.Nohavec@umb.com.