White paper from John Barrickman
It’s one of the great ironies of economic cycles: There will be some companies that scratch and claw their way through the downturn, managing to survive the worst of the recession, only to fail when the recovery starts to kick in.
The primary culprit is usually a lack of access to capital. Here’s a typical scenario: By aggressively managing down its receivables and inventory and putting off replacing fixed assets, XYZ Company has been able to reduce its financing needs and stay in business the past couple of years. Now, things are starting to look up from a business development standpoint, but growing sales requires an investment in fixed asset as well as working capital to fund new receivables and inventory to support the higher level of sales.
Due to recent losses and excessive leverage, however, the business no longer qualifies for a working capital loan or line of credit. There are a number of these “zombie” businesses in the marketplace today that will bleed themselves dry of capital without help in the form of some sort of external cash infusion.
This problem will likely be widespread in 2010 due to the tighter lending standards adopted by most banks and the disappearance of many traditional small business lending sources (like credit cards and home equity lines of credit). These factors have made it difficult for even well-established and creditworthy companies to obtain financing. Many solid firms have seen their credit lines slashed or even eliminated altogether, while others cannot obtain the financing they need for working capital, expansion or growth.
Financing: Know Where and How to Look
While there’s no question that getting a business loan is more difficult in today’s economic environment than it was two years ago, it’s not impossible. Yes, there are banks out there that are willing to approve loan requests from companies with strong management, viable core businesses and owners with good business plans. The main keys to financing success are knowing where to look and how to prepare.
Most business owners and CEOs would do well to start their search for financing at a community bank. In general, community banks have weathered the financial storm better than their big bank brethren. Many have relatively healthy balance sheets, which gives them not only the ability, but also the desire to lend money to small businesses.
Also, look for banks with strong capital positions, good portfolio credit quality and solid core funding (i.e., banks that rely on local deposits rather than purchase funds), as well as those that have avoided heavy concentrations in acquisition, development and construction lending. Many of these banks, in fact, are targeting the best customers of their distressed competitors, recognizing that this is probably one of the best business development opportunities in years.
As a business borrower, however, you should realize that healthy banks that are lending money now have implemented more stringent terms and enjoy pricing power, which means a loan may cost you more today than it would have a couple of years ago. But don’t think of it as gouging; rather, these banks recognize the realities of the current marketplace and are pricing loans appropriately for the additional risk they’re assuming in today’s volatile environment.
Determine Your Financing Need
Before you begin preparing to apply for a business loan, it’s helpful to understand how bankers view small business loan applicants.
Let’s start with a very basic but often overlooked concept: Only cash pays loans. Therefore, the most important thing a banker will seek to gauge about a potential borrower is the amount of cash flow that will be available to service (or repay) the debt. Since today’s loan will be repaid with tomorrow’s cash flow, your banker will take the historical performance of your business and project this into the future.
The first thing a banker will usually try to determine is what is the appropriate type of loan product for your specific financing need. When it comes to business financing, all loans are not the same, nor are they all structured the same way.
One of the most common types of small business loans is the business line of credit. With this type of loan, your business can borrow up to a pre-determined amount of money. Typically, your bank will expect you to be able to “clean up” the credit line (or pay it down to zero) periodically during the year, or term out any outstanding balance. In order to do so, however, you must use the line only for the purposes agreed to by you and your banker — usually, as a temporary investment in current assets.
A common mistake many business owners make is not understanding the difference between a temporary and a permanent investment in current assets. Businesses that experience heavy seasonality and those that deal primarily in contracts often experience temporary cash flow gaps, and tapping a line of credit may be appropriate for helping plug them.
The problem occurs when borrowers use their line of credit to fund a permanent investment in current assets. Here’s how that usually looks: Inventory is sold and receivables are collected, but as soon as the money is in the bank, it has to be reinvested in new receivables and inventory in order to keep the business afloat. The borrower is never in a position to pay down the line, and is therefore vulnerable to the line possibly not being renewed by the bank.
In this scenario, the banker will eventually need to “term out” the line of credit, or convert it into a long-term loan that’s designed to finance a permanent investment in current assets. This example helps demonstrate the potential problems that can arise by not identifying the specific financing need so that the right loan product is identified in the beginning.
Measuring Cash Flow and Prioritizing Use of Cash
There are several different methods banks use to help them determine the amount of cash flow that will be available to service a borrower’s debt. An important thing to keep in mind, however, is that while these methods will measure a borrower’s ability to earn its debt service, they don’t address the borrower’s ability to pay the debt service.
This is critical to bankers. A borrower and banker must reach agreement early in the lending relationship on the priorities for the use of cash, and when it’s appropriate to change these priorities. For example, should cash be used to grow the business, support the owner’s lifestyle, or repay the loan? Most owners, not surprisingly, would tend to prioritize the first two, while bankers are obviously most interested in the last one.
To gauge a borrower’s ability to pay debt service, the bank will want to find out what is actually happening to the cash generated by the business — or in other words, where cash came from and where it went. This is where the statement of cash flows comes in. There are several different approaches that can be used to present cash flow. Given how closely intertwined the business and personal affairs of many small business owners have become, many banks today are moving toward an integration of business and personal cash flow into what is called global cash flow.
A challenge for many small business borrowers is balancing their desire to manage earnings in such a way as to minimize tax liability while still being able to demonstrate to a banker the ability to repay a loan. Some owners have been so aggressive in managing earnings in order to reduce their tax liability the past few years that they can’t show adequate income to qualify for a loan. This highlights the importance of investing in top-notch accounting and financial systems that will enable you to present the kind of quality financial information needed to qualify for a small business loan.
Your accountant can help you here, whether by preparing compiled financial statements, instead of just tax returns, or helping with the timely presentation of Schedules K-1 to give your banker an accurate picture of your multiple business entities and how they’re interrelated.
What You Can Do Now
Given all of this, what are some specific things you can do now to put your company in a better position to obtain business financing?
Here are five suggestions:
1. Scrutinize your cash flow. It all starts and ends here. This is the first thing your banker is going to do, so you may as well go through the steps detailed here to assess the adequacy of cash flow to service debt yourself before approaching your banker for a loan.
2. Assess your potential collateral and the level of owner’s equity in the business. The next thing your banker will do is look for a second way out in the form of collateral if you cannot repay the loan. He or she will be especially interested to see if you have any “skin in the game,” or in other words, how much of your own personal assets are invested in the business.
3. Be willing to adjust your lifestyle. Among the biggest fixed costs in many small businesses are the corporate and personal lifestyles of the owner. During the boom times, many owners got accustomed to living the good life: big house, fancy car, private schools, expensive vacations. Your banker may want to see evidence that you are willing to make some sacrifices and downsize your lifestyle if this will help the numbers add up.
4. Focus on the “five Cs of credit.” At many banks today, a back-to-basics approach has become en vogue as lenders return to the traditional emphasis on what are known as the five Cs of credit: Character, Capacity, Collateral, Capital, and current market Conditions.
5. Work closely with your accountant. The Whitlock Company can play a vital role in your quest for financing — primarily by helping you implement good systems through which you can present quality financial information to help your banker gauge the factors that go into his or her lending decision. Please contact us with any questions.
About the author:
John Barrickman is President of New Horizons Financial Group. John is a former bank CEO and current faculty member at several major domestic graduate banking schools where he is continually exposed to the credit processes of banks of all sizes.