A loan to grow on

guest commentary by David Potts

A growing business will eventually need to borrow money, almost without exception. Commercial banks, according to my friends who work there, want to loan money to growing businesses. The only catch is that the banks want to be paid back, with interest.

When you apply for a loan you might not be convinced that banks are in the business of lending money. A common sentiment of new entrepreneurs having difficulty financing their start up business is that banks only loan money to those who don’t need the money. Or maybe you have been in business for years and can’t figure out why the bank isn’t jumping for joy when you ask to borrow a few hundred thousand dollars for new equipment to expand, but instead want as collateral all your available assets, your personal guarantee, your wife’s personal guarantee, audited financial statements and anything else they can squeeze out of you for their protection.

Maybe a paradigm shift could help you understand what’s really going on. Let me challenge you to look at your loan request from the bank’s point of view. Doing so will probably increase your odds of successfully obtaining a loan that fits your company’s financing needs. Learn how your loan officer thinks.

A bank is a business. The purpose of any business is to make money for its owners. So when you talk to your loan officer, remember he is asking himself if your mutual relationship will be profitable for the bank. He is worried that you might not be able to pay the loan back and he has a boss to pacify. It helps that he likes you, but liking you isn’t a criteria for lending you money. However your character could be an issue. A conviction for embezzlement might not be in your favor, but a reputation for honesty will.

Your loan officer will consider the viability of your business. He will ask himself, “Does this business idea make sense?” and if the concept passes the “it makes sense” test, he will want to know if your business model makes sense. By business model I mean the overall way you plan to operate your business; your marketing plan, your cost structure, your distribution channels. Will your business be profitable?

Your loan officer will evaluate your resume, your education and experience in the industry your business operates. What are your capabilities? If you have managed a restaurant for the last 15 years and you are now inspired to start an import/export furniture business without any industry experience, your loan officer will be skeptical of your potential for success. It’s your job to demonstrate your ability to succeed.

So how do you educate and inform the bank that your business makes sense and you have the experience and ability to succeed in your business? The best way is a well-written and well-researched business plan. Make life easy for your loan officer. Like everybody else he is short of time, doesn’t want to work harder than he has too, and he may give higher priority to another customer that might require less time and effort who would be just as profitable to the bank as you.

Another way to make life easy on your loan officer is to prepare a cash flow projection and clearly state your assumptions. If your business is not a start-up business, present him with accurate historical financial statements. As part of the loan application process, the bank will prepare a financial analysis on your company. A financial projection can demonstrate you understand the costs of operating your business. If they accept your numbers you may have more positive results. If the bank has to generate their own projections, I bet their numbers will be more conservative than yours.

Keep in mind that all these questions and all the analysis is to determine the probability of your ability to pay the loan back. One of the most common indicators of your ability to pay the bank back is the debt coverage ratio. The debt coverage ratio is basically annual net cash flow divided by annual debt service. A ratio of less than 1 means your company can’t pay the loan back based on current or projected cash flow. If your debt coverage ratio is less than one kiss your loan goodbye. I surveyed several of my commercial loan officer friends and it appears that the minimum debt coverage ratio required to be approved for a loan in Fort Smith is between 1.15 and 1.3.

Remember that a bank is not a venture capital fund. Your loan officer will want to see that you are risking something. If you really believe in your business concept why wouldn’t you be willing to be at risk too?  You need to have your own money, some equity in your business. Most loan officers would expect to see you take a 15% to 20% equity stake in a new business or business expansion or even just an asset you might purchase. And of course you will be asked to provide some collateral to back the loan. Be prepared to offer some or all of your assets as collateral. If your collateral is a non-financial asset like unimproved acreage or jewelry, determine its fair market value in advance. Providing him information before he asks will show you have attributes that lead to business success — the willingness to prepare and work hard.

Banks will look to your accounts receivable and inventory for collateral and determine how much they will loan your business based on a “lending base.” The lending base is usually calculated as a percentage of you inventory and a percentage of your “qualified” accounts receivable. For example, they may loan you an amount up to 50% of your inventory and 75% or your accounts receivable outstanding less than 90 days.

There are many factors that go into lending that lay below the surface and won’t be discussed in conferences with your loan officer. Since banks want to make money they have to be experts in risk management. One of the basic tenants of risk management is diversification. It is possible that you won’t get a loan because the bank has already loaned too much money to other companies in your industry, even when your company may be worthy of a loan.

Some banks make their lending decisions locally and others have to send the loan package to a committee out of town or out of state. It’s my impression that banks that make their loan decisions locally are quicker to approve or deny your loan request and are more willing to accept risk on the local level. But I wouldn’t swear this is true. If you’re concerned, make it a topic of conversation with your loan officer.

Banks have personalities. Some banks can stand to accept more risk than others. Just because one bank turns you down doesn’t mean the next one will. If the loan officer tells you he can’t loan you money, ask him which bank might. Banking is their business. They know which bank in town accepts the most risk. I do and I’m not a banker.

I have personally found that your “customer experience” is just as dependent on the loan officer’s assistant as the loan officer. I have changed banks before because the loan officer’s assistant went to work at another bank and I followed this person to the new bank because they were the one who always took care of me. It’s always wise to remember to buy them a small gift around Christmas time.

One last thought: you might consider that the loan officer who denied your loan application is doing you a big favor. It is possible that your business idea, the one you believe will change the world for the betterment of mankind, just isn’t economically feasible. Loan officer’s see a lot of businesses — businesses that are hugely profitable and businesses that end in bankruptcy. They develop a sense of which business plans will work and which won’t. If your loan is denied, ask them if there is anything in your business plan that doesn’t make sense. It could be that your idea is really unworkable and you just can’t see it yourself. The stress and financial aftermath of a failed business can haunt you for years to come. Listen and learn from your loan officer.

All businesses have key people. Although a commercial loan officer is not your employee, he should be a key member of your business team. Develop your relationship with him. If you tell him you will do something, do it. Take him to lunch and tell him what is going on in your business on a regular basis. He is your friend not an adversary. You will need him one day. He can help your business succeed.

In my next commentary: If your bank won’t loan you money, what’s next? Should you just give up? Probably not.

David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas at Fayetteville. You can follow more of his thoughts by reading his blog at ThePottsReport.com.