How do traditional banks evaluate business credit? - by Jeff DeVine

By Premier Professionals on Oct 01, 2014 at 09:29 AM in Santa Barbara Professional Services

by Jeff DeVine, President & CEO of American Riviera Bank

American Riviera Bank Logo
How do traditional banks evaluate business credit? - by Jeff DeVine
Jeff DeVine
President and CEO
American Riviera Bank

It is important to note that traditional banks are conservative out of necessity. We get a bad rep for it but here is why:

  • We lend our depositors’ money and they will want it back at some point. The FDIC regulates all banks closely and scrutinizes the safety of the loans we make with our depositors’ money.
  • A “well performing” bank earns a 1% return on assets. A bank’s primary asset is its loan portfolio.  A “well performing” bank with $100 million in loans will make $1 million in profit. However, if a single $1 million loan goes bad, the bank’s profit for an entire year is wiped out.

The basic formula for traditional bank lending never really changes. Banks look at Cash Flow, Collateral and Character of the owners/officers of the business otherwise known as the “3 C’s of credit”:

  • Cash Flow. Banks want to know that the business can afford to pay the loan back over time. A Bank will want to see 2 years of financial statements that demonstrate adequate historical cash flow to make the loan payments. For a short-term revolving line of credit, that cash flow will be “operating” cash flow generated from the normal business cycle. For example, a company borrows to purchase or manufacture inventory; inventory is then sold to generate an account receivable; and an account receivable is then collected in cash to pay the loan advance back. For a long-term equipment or real estate loan, the bank will look to “traditional” cash flow defined as net profit adjusted to add back interest, taxes, depreciation and amortization (EBITDA).
  • Collateral. Although advance rates may vary banks often lend up to: 100% against cash deposits, 50% against investment grade marketable securities, 70-80% against current accounts receivable, 50- 75% against used equipment value, 80% against new equipment value, 30-40% against finished goods inventory and 70-75% against owner occupied commercial real estate.
  • Character/Guarantors. The bank will evaluate the character, experience, liquidity, net worth, personal cash flow and credit history of potential Guarantors. A FICO credit score of under 650 is generally unacceptable, 650-680 is marginal, 680-700 is marginally acceptable, 700-740 is good, and over 740 is excellent.

I like to use a rule of thumb that if your business has two of the three key characteristics listed above that are acceptable; then your business is probably bankable. If you only have one; traditional bank finance may not be right for you. For example:

  • Cash flow and Collateral. This is the best situation. In fact, your bank may agree to not require Guaranties or place less emphasis on Guarantor credit score/financial condition.
  • Cash Flow and Guarantor. This is still ok. You may have a “retail” or “service” type business with limited receivables, inventory or equipment.
  • Collateral and Guarantor. This is really not a preferred situation for the bank because it means that your Cash Flow must be questionable or negative. However, you will still be able to get a loan if your Collateral and Guarantor are strong, and you can make a case that you have taken steps to improve the Cash Flow disruption (for example, increased prices or decreased expenses).
  • Cash Flow only but no Collateral or Guarantor. This could be a great business to own but there is simply too much risk here for a traditional bank. If your Cash Flow is interrupted then how does the loan get repaid with no Collateral or Guarantor support? Maybe you are a “retail” or “service” type business and can accept cash and credit cards. You may not need a traditional bank loan anyway.
  • Collateral only but no Cash Flow or Guarantor. You may want to talk to an asset based lender or factor that will lend against your purchase orders, receivables, inventory, or equipment. Beware,
    these are hard money lenders that charge higher interest rates and may not be shy about stepping in to collect or repossess assets if you don’t make your payments.
  • Guarantor only but no Cash Flow or Collateral. You may be in the early stages of a business start-up. You have good personal credit and a good business plan. Depending on the type of business you may want to speak with the SBA, Cal Coastal, Women’s Economic Ventures, angel investors or venture capitalists.

If my business does not qualify for traditional bank financing or SBA/Cal Coastal loans where can I turn? Is there a work around?
Yes there are still options. Let’s go over a few in order of preference:

  • Address the issue and re-apply. It may be that the bank, SBA or Cal Coastal declined your loan because you have too low of a FICO score. There are various reasons for a low FICO score but a couple can be addressed quickly. Get any delinquent payments current and reduce revolving borrowing to no more than 50% of total available credit. Delinquencies and high line usage of individual and overall revolving credit lines can really hurt your FICO. Use one of the ideas listed below to clean up your personal credit for 2-3 months and re-apply.
  • Accelerate your cash flow. Don’t offer terms to your clients. Only accept cash or credit card. If you need to offer terms see if you can get a deposit up front to at least cover your costs so that you are only waiting to collect your profit on the receivable. If that does not work, approach your clients that owe you money and offer them a discount to pay you quicker. For example, your client may typically pay you in 30 days but if you offered a 2% discount they may agree to pay you this week. Your profit margin has to be strong enough to handle the discount or you may lose money on the sale. This may be ok if you are in a crunch and need to make payroll. Offer promos or punch cards that provide a valuable discount if services are prepaid.
  • Defer your expenses. Approach your suppliers. See if they will agree to offer you terms rather than accepting only cash or COD. They may be in a position to do so, and may value your long-term relationship as a client. If you ask for terms and get approved, you must do your best to live within the terms. If you take advantage of your suppliers too often they may lose faith in you and rescind your terms when you need them most. If you are in a really bad situation, ask your suppliers to take back a promissory note for what you owe them. This may permanently damage your relationship, but it may be better for both parties than bankruptcy.
  • Borrow from friends/family. Often a very lenient and fair lender. However, honor and performance are key. Many family members and friends no longer speak after a sour lending arrangement.
  • Find Investors. If you have a rapidly expanding business or hot business concept approach individual investors, strategic business partners or venture capitalists. The drawbacks are that you will have to give up some ownership, voting rights and independence when dealing with a third party investor. However, owning a fraction of a really big business is better than owning 100% of a really small business. Just ask the founders of Google.
  • Factor your receivables. A factor will buy your receivables at a discount. You get the cash now less the discount. The factor keeps the entire receivable when your client pays. There is a difference between “discount” and “annual percentage rate.” If a factor buys your receivable at a 1.5-2% discount that will collect in 30 days your annual percentage rate (cost of credit) is 18-24%. Factoring arrangements vary, but in some cases your factor will have recourse back to you or your business if your client does not pay on schedule. In addition, factors sometimes contact your clients directly and you may be unable to avoid your client knowing that you factored their receivable.
  • Borrow from asset based lenders. These finance companies will lend against purchase orders, inventory, accounts receivable and equipment at higher advance rates than traditional, SBA or Cal Coastal lenders. However, hard money lenders will charge higher rates which can make it more likely that you will default on payments if things don’t go according to plan with your business. In extreme cases, these lenders may be interested in taking over your business or repossessing your