Zombies have long been popular among a certain segment of moviegoers, but what does this have to do with commercial lending? The present state of the economy and the small business segment, in particular, is starting to resemble a modern-day zombieland. There are a number of businesses today that can best be described as “the living dead.”
They managed to survive the recession by aggressively managing receivables and inventory and delaying replacement capital expenditures, but are destined to fail once the recovery starts kicking into gear.
Here’s why: As sales rebound, they will need to rebuild working capital in order to fund new receivables and inventory and fill new orders. However, they no longer qualify for working capital loans or lines of credit due to losses and excessive leverage. Without some sort of external cash infusion, these companies will soon bleed to death for lack of capital.
Picking Winners and Losers
With the much tighter lending standards now in place among most lenders, not to mention the disappearance of many traditional sources of financing for many small businesses (think credit cards and home equity lines of credit), this problem may become widespread as the year goes on.
As a commercial lender, you have to decide which survivors you’re going to support and which ones you aren’t. Here are a few questions to ask about companies as you try to make this determination.
- Is there still a viable core business, strong management team, workable business plan and solid customer base in place?
- What is the company’s value proposition distinguishing it from competitors? Does it offer products or services that meet a unique need in the marketplace and that customers will be willing and able to buy as the economy recovers?
- What is the company’s current working capital position? Is there access to capital beyond just a bank loan; for example, the owner’s personal savings or family and friends?
- How strong are the company’s internal controls? Does it generate timely financial information? Is management willing to invest in systems that allow current monitoring of receivables and inventory?
- Is the owner willing to make personal sacrifices (if he or she hasn’t already) in order to keep the business afloat? This may include scaling back lifestyle choices and putting some of his or her own capital into the business.
- Has the company made large investments in non-productive fixed assets?
- Does its current debt exceed three times the business’ net worth?
- Is the business in, or is it dependent on, a currently troubled industry, like transportation (especially automobiles), financial services, construction or income property?
Focus on Cash
As you survey the small business landscape and decide which borrowers you want to lend to and which are “zombies,” it’s worth brushing up on a few of the basics of small business lending. Let’s start with a concept that was often overlooked in the run-up to the financial crisis: Only cash repays loans. As many banks are learning the hard way now, a heavy reliance on collateral only goes so far in today’s environment.
The most important thing to determine about a potential small business borrower is how much cash will be available in the future to repay the debt. To calculate this, you must project the company’s historical performance into the future. Of course, the past couple of years have been anything but normal for many companies, so keep this in mind as you analyze projections.
There are several different methods that can help determine the amount of cash flow available to a small business borrower in order to service debt. It’s important to note, however, that while these methods will measure the company’s ability to earn its debt service, they will tell you nothing about its ability to actually pay the debt service, which is the factor that’s most crucial to your bank.
Therefore, it’s important that you and potential borrowers prioritize the use of cash and, just as important, determine when it may be appropriate to change these priorities.
One common example: Should cash be used to grow the business, support the owner’s lifestyle or repay the loan? Not surprisingly, many owners will prioritize business growth and their lifestyle, while you prioritize loan repayment.
Statement of Cash Flows
The most important thing to determine as you gauge a potential borrower’s ability to repay debt is simple: What is happening to the cash the business generates? Put another way, where did cash come from — and where did it go?
To find out, you’ll need to scrutinize the statement of cash flows. While there are several different approaches that can be used in the presentation of cash flow, many banks today are moving toward an integration of business and personal cash flow into what is called global cash flow. This is due to the close relationship between the business and personal affairs of many small business owners.
Unfortunately, many owners have done such a good job of managing their earnings to minimize tax liability that they can’t show enough income to qualify for a loan. You can help potential borrowers by encouraging them to invest in quality accounting and financial systems that will help them present the kind of information you need to determine whether or not they will qualify for a loan.
Also encourage borrowers to turn to their accountants for help. For example, they may be able to prepare compiled financial statements (instead of just tax returns) or present Schedules K-1 to give you an accurate picture of multiple business entities and their interrelationships with each other.
If you have borrowers who need assistance with their financial and accounting systems, please contact us to discuss how we can help them.