By Phillip Perry
Here's good news for businesses that need money for renovation or expansion: Financial institutions are more eager to lend than at any time since the Great Recession.
“As more banks have worked their way back to profitability in recent years, there has been a loosening of the purse strings,” said John McQuaig, managing partner at the management consulting firm McQuaig & Welk (mcqw.com).
The trend is likely to continue, for several reasons. One is the anticipated loosening of federal regulations that have restricted bank lending practices. A more immediate force, though, is the higher cost of money. “Rising interest rates improve banks' margins, and if they become more profitable they can potentially lend more,” said Linda Keith, a CPA with a niche practice in lender credit training (lindakeithcpa.com).
Of course, higher rates are a two-edged sword. They also increase the costs of money for business customers, and the higher payments make it harder to qualify for loans. “Most small businesses that obtained variable interest rate loans in 2016 or earlier will see an increase in their monthly payments,” said Denise Beeson, a small business consultant (denisebeeson.com). “For some borrowers, this increase may not be substantial. However, we anticipate further rate increases in 2017.” Even so, the nations' historically low interest rate environment means there is still some room for rates to grow without having a huge impact.
An improving commercial real estate market is also driving more business lending in most regions of the country. That's good news for anyone using property as collateral. “Many banks are now willing to lend up to 80 percent of property value, higher than the 65 percent to 70 percent in the years following the Great Recession,” said McQuaig.
That happy condition is not universal, however. In some areas the real estate market has overheated, sparking fears of overvaluations. As a result, some banks are reducing the amounts they will loan on appraised value.
“Banks need confidence in the local market and in real estate appraisals to support loans,” said Keith. “They will ask themselves, ‘Do valuations really reflect what a seller can get for the property?'”
Despite the improving lending environment, one thing hasn't changed since the dark days of 2008: A heightened banking interest in customer cash flow. Indeed, while collateral can be important for the lending machine, it is no longer a driving gear.
“Banks are looking for quality performing loans,” said Keith. “They want to see, first, that the business borrower can repay a loan using cash flow generated from operations. Second, they want to see good liquidity, so if the operations don't come off as planned the borrower has enough money to pay as agreed.”
As a third line of defense, added Keith, banks look for a personal guarantee: Does the owner have enough funds to backstop the business? And finally, what's the current debt load? Does the business have room to borrow more?
It all comes together to produce a loan decision, “With those various potential sources of funds,” said Keith, “the bank hopes it will not have to collect on the collateral.”
Of the four indicators mentioned above, the most critical is the first: debt coverage (the ratio of net cash flow to annual principal and interest payments). Banks expect business borrowers to generate 120% to 130% of their total loan payments in net cash flow.
Here's an example: Suppose annual payments for principal and interest come to $100,000. At least $120,000 in cash flow must be generated after all other expenses are paid.
And that 120% figure is a bare minimum today, said Keith. Banks are more comfortable with 12%. For reference, back in the Great Recession they were requiring a 13%.
Small is Good
“Finding the right bank for your deal is important,” said Brad Farris, principal at Anchor Advisors (anchoradvisors.com). “A big megabank offers complex and large financing, and the decision to lend is all about the numbers. Your local community bank, on the other hand, provides leasing and lines of credit and SBA real estate loans, and the decision to lend often depends on your relationship with a human being.”
That personal touch can be critical. “You want a bank that understands what you are doing and what your plans are,” said McQuaig. “A community bank is more likely to do that. While bigger banks are looking to serve big customers, smaller ones may use other means to qualify business loans beyond a simple analysis of cash flow.” Credit unions, too, said McQuaig, are expanding their commercial activity, but are still not terribly experienced in that area.
Smaller banks are of special importance because of their dependence on small business lending, said Keith. “Their very survival depends on finding quality loans. This is great news for small businesses with good fundamentals.”
But know the downside. “The smaller banks have to be very careful how much they lend, because they have a smaller pool of funds,” said Andrew Clarke, president of the small business consultancy Ground Floor Partners (groundfloorpartners.com). “A $100,000 loan default is a much bigger hit on a $20 million portfolio than on a $500 million one. Bigger banks might have tougher terms, but at least they have money to lend.”
When it comes to landing a loan, numbers alone won't carry the day. “Start talking with bankers to build relationships long before you need money,” advised Clarke. “If bankers know you to be a reliable, serious person you will have a much better chance of getting a loan approval. That's true even though small bankers do not have much direct authority, since underwriting decisions are often made elsewhere. Even so, they can grease the wheels.”
Successful communication is an ongoing process. “Market to your banker like he's a business prospect,” said Farris. “You need a plan for feeding your banker news about your company and what is happening, so the banker feels comfortable with what you have borrowed. Manage the perception of what is going on with your business.”
Communication is a two-way street: Keep yourself tuned to what is happening at your bank—especially about any changes that might disrupt your credit line. Business people often assume their lines of credit are safe as long as they maintain their covenants. But that is not always the case. “When a bank wants to pull your loan it can come up with a rationale,” said Clarke. “It can find some financial ratio it doesn't like.”
Be especially wary of bank mergers. “When a big bank buys a small bank there always seem to be unwanted assets that do not fit well with the portfolio,” said Farris. “So the combined bank often refuses to renew certain lines of credit, or refinance loans. And that creates a lot of disruption in the customer base.”
Finally, be alert for a common pitfall: The tendency of small business bankers to move from bank to bank. “You build a good relationship so your banker will help you out when the time comes to borrow money,” said Clarke. “But all of a sudden you find your friendly banker has gone to a new employer and has not yet cultivated those internal relationships required to help you get your loan.”
How to Land a Loan
How can you prepare for a successful business loan application? Follow these tips from Beeson:
- Understand how much money you are seeking and why. What are the uses for the proceeds?
- Check the quality of your credit score and that of your business partners.
- Automate your business. Are you using a good accounting software program and do you have an active website so you can show your business is up to date financially and technically?
- Will the banker be impressed by your professional team? Even the smallest of businesses can assemble an experienced accountant, attorney, industry consultant, and marketing advisor.
- Shop around. Some financial institutions offer business expertise assistance and a competitive basket of services.
Perry has published widely in the fields of business management, workplace psychology, and employment law. He can be reached at email@example.com.
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