Loan Officers

What Do They Look For?

Clinton W. Daley 

BizJump Quarterly, 2001 number 1 (First of a 3-part series)

ecently while attending a small business seminar on financing, I had some very pointed discussions with several furious small business owners, whose requests for financing were denied by their bank. "Banks don't care about small business" or "They [banks] don't understand my business" were some of the comments that were reiterated by many business owners.

Although some banks are very conservative and small business unfriendly, business owners in many cases are to be blamed for not obtaining funding from banks. According to John Tear, a bank Vice President, "Many business owners approach banks not knowing what we are looking for." He continued, "It's no secret that many entrepreneurs are clueless when it comes to understanding the loan process and criteria that banks use to approve business loans."

Small business owners will significantly increase their chances of obtaining a business loan by becoming knowledgeable about the criteria loan officers use in determining whether a proposal is bankable. Usually lenders will approve a business loan if the proposal meets all the criteria of the "5 Cs": Capital, Capacity, Collateral, Character and Conditions.

The Five C's of Credit

 Capital.

In order to survive during its first few months, a business must be sufficiently capitalized, i. e., a business cannot grow unless it has a strong capital infrastructure, like cash, equipment and inventory. Lending institutions will only provide financing to business owners who have committed a significant amount of their own cash to the business. Usually this amount is about 40-50% of the total capital need. No lender will approve a loan for 100% of the total funding needed. In that case they would be taking a significant risk, but their expected return on their investment would be limited to the interest they charge on the loan. Furthermore, a business owner who has no investment in the business probably won't stick it out when the going gets a bit rough (and believe me it will).

Capacity

This deals with the ability of the business to repay the loan out of its ongoing operation. In order to repaying the loan on a monthly basis, the business must have a positive cash flow. In fact, of all the other financial statements, many bankers consider the cash flow statement to be the most important. Although it is important for a business to make a profit, it is equally important for the business to have a positive cash flow. There are numerous cases where a business that is showing a profit goes bankrupt because of lack of cash. One of my clients had grown his construction business from a $60,000 in annual revenue to over $500,000 within 4 years. The business was showing a healthy profit of $77,000. However, it was at the brink of bankruptcy. Why? The answer was obvious. The business was not collecting its bills on time. Seventy percent of its receivables were over 60 days old. Consequently, the business had no cash to meet its current financial obligations.

Collateral

Although a lender's willingness to approve a loan is a sign that they believe in the business, they still want some sort of guarantee that they will get their money back in case the venture fails. One way that they secure this guarantee is by asking the business owner(s) to put up some type of asset as collateral for the loan. Examples of collateral are real estate, money market accounts and equipment. Usually banks will place more value on collateral that can be easily converted to cash, since in the case the business fails, the bank can easily liquidate the asset.

Character

According to SBA statistics, 4 out of 5 businesses that fail do so as a result of incompetent management. Being cognizant of this fact, lending institutions pay very special attention to the owner's ability to manage the business. In particular, lenders want to ensure that the business owners have sufficient experience in the line of business that they want to start. For example, if the business owner wants to start an auto repair shop, lenders will be checking the principal's experience working in or managing an auto repair shop. In addition to the principal's experience, lenders will scrutinize personal credit reports to verify the business owner's history of repaying debts. Some banks, especially the larger ones, sometimes use a credit score procedure to determine the business owner's qualification for a loan. If the score falls below the qualifying numerical range, the application will be automatically declined. Other banks might be willing to look at the application even if the credit is not that great. However, the business owner must demonstrate that he/she has made significant efforts to fix whatever past credit problems. This was the case with a client whose loan for his service business was approved, even though he had a personal bankruptcy 3 years prior to applying for the loan. In this case, he was able to convince the banker that his bankruptcy was as a result of extenuating circumstances. Additionally, the bank was impressed with his over 20 years of experience in the line of business that he wanted to start.

Conditions

Condition usually describes external factors that lenders consider in assessing a loan proposal. Examples of such factors are: state of the economy, interest rates, legal issues and the lender's own experience with lending to similar businesses in the client's industry. Legal issues such as new EPA (Environmental Protection Agency) standards, impact on many banks' decision not to lend money to gas stations because many of them would be unable to meet the new environmental standards and probably would go out of business as a result. In some cases, banks are reluctant to lend money to businesses that are in industries where they have had bad lending experience. One loan officer said that his bank would not do loans for construction companies because of three recent loans to construction companies gone sour.

In most cases, if a business is very strong in all the above criteria, the owner should not have much problem obtaining a business loan. However, for many business owners that's not the case. Hence, business owners must do their homework to not only find a lender that will work with their current situation, but also they must prepare a solid proposal before meeting with the lenders. These two issues will be covered in the Part II (Where Should I go to Get Funding for my Business?) and Part III (What Must I do Before I Approach a Bank?)