Banks are for-profit businesses. They get paid to take on a certain amount of risk. Typically, the interest rate and the terms and conditions offered to you as a client reflect the level of risk your bank incurs by lending to you and your business. The bank looks to mitigate risk by structuring deals appropriately. This may include additional covenants, guarantees and/or collateral.
In order for a bank to make sound lending decisions, bankers and commercial underwriters evaluate the credit risk of each customer and potential customer through a process called Credit Analysis.
This article should be used as a guideline by business owners and executive management as it relates to the underwriting/approval process.
By understanding these key credit parameters, you can better prepare for the credit underwriting process. Have you ever heard of the 5 C’s of credit? This is an old school way for your lender to assess your risk as a borrower. The 5 C’s are as follows:
- Character – Your credit “character” speaks to the integrity of the owners and management given that these stakeholders are closely tied to the success of the business. Banks are interested in your work experience and your personal credit history. The bank may ask for a bio and may require a personal guarantee on the commercial loan.
- Capital – Banks will look at the amount of capital assets held by your business. This includes cash, equipment, inventory, real estate, etc. The bank also wants to know how much capital has been invested into the business by the shareholders/owners. Given the amount of risk taken on by a lender, they want to know that you have skin in the game as well.
- Collateral – Collateral consists of the capital assets of your business such as commercial real estate, accounts receivable (AR), inventory, cash, equipment, etc. The bank will look at the value of your collateral as well as any existing liens/debt that your business may owe to a lender.
Although exceptions are made, Banks typically lend using the following advance rates:
- Up to 80% of Eligible AR (Asset Based Lending and Government Contracts may have a higher advance rate);
- Up to 60% of Inventory (excluding Work In Process);
- Blanket Lien on Furniture, Fixtures and Equipment (advance rate of 25%-50%);
- Up to 80% on Specific Equipment;
- Commercial Real Estate (typically up to 80%);
- Land (up to 65%);
- Marketable Securities and Bonds (Advance rates range from 50% to 90%);
- Cash has an advance rate of 100% (deposits typically held at the lending bank).
- Other collateral may include Cash Value of Life Insurance and Annuities (80% advance rate). SBA loans may allow for different advance rates.
4. Conditions – The lender will also consider the conditions of the environment in which you operate; many times, these factors are outside of your control. External factors may include issues within your industry, competitive advantages/disadvantages, regulatory environment, technology implications, and economic cycles.
5. Capacity – Does your business have the financial capacity to support the proposed debt along with your other expenses? The bank will assess your cash flow situation as well as your debt to net worth. The following Covenants may be added to your loan agreement to address risk:
- A requirement for Debt Service Coverage typically greater than or equal to 1.20 to 1.00 on a TTM basis.
- A requirement for Fixed Charge Coverage typically greater than or equal to 1.10 to 1.00 on a TTM basis.
- Maximum Balance Sheet Leverage typically less than or equal to 3.00 to 1.00.
- Cash Flow Leverage may also be measured depending on the purpose of the loan.
When you understand the credit underwriting process and key credit parameters, you can better assess the financial strength of your company and your credit risk profile.
As you consider your financing options in the marketplace, remember that interest rates and loan structures often vary with the credit and/or investment risk of the company. The strongest companies often receive the best rates and deal terms and conditions. It’s important to consider a few different options and be ready to negotiate with your bank as it relates to interest rate, terms, conditions, covenants, etc.
To learn more about LonaRock, LLC and our debt finance consulting services, please visit our website at www.lonarock.com or contact us directly at 234-217-9033. We look forward to helping you become an ideal business client and helping you obtain the best possible financing for your company!