Phillip M. Perry (Winter 2012)
If you're like most small business owners you're finding it tougher than ever to negotiate with your bank. Loans are harder to come by. Fees are thicker on the ground. The reluctance of banks to lend money can make it tough to fund operations. Even so, bank experts say the financing picture is not all gloom and doom.
"The popular belief that banks are deliberately holding off on lending is a fallacy," says John McQuaig, managing partner of McQuaig & Welk, the Wenatchee, Wash.-based management consulting firm. "Banks are anxious to lend money, but they are unable to find enough good loan prospects," McQuaig explains.
Surprised? Maybe so, if you've just been turned down for a loan. Here's the problem: The definition of "good loan prospect" has undergone a fundamental change in this economic environment. "Loan decisions now are based on cash flow," says McQuaig. That's fundamentally different from the lending paradigm of a few years ago.
"It used to be that banks would give you credit for the value of your inventory or your building or other hard assets," says McQuaig. "That's not the case today, unless you have good cash flow as well." (Cash flow is often defined as net profit plus interest expense plus non-cash charges such as depreciation and amortization.)
What's a good rate of cash flow? While the answer varies by bank and customer, there is a well-known rule of thumb: "There is an understood benchmark in the banking industry that a business must generate 120 percent of its total loan payments in cash flow," says Bill McDermott, CEO of Atlanta-based McDermott Financial Solutions. "So if you will be paying $100,000 a year in principal and interest, then your business had better generate $120,000 in cash flow," McDermott notes.
Why have banks turned more conservative? One reason is a tough regulatory environment growing out of the crisis of 2008. "Regulators are putting the clamps down on banks, working overtime on reviewing loans," says McQuaig. "There is still a lot of fear on the regulatory side."
There's another reason: uncertainty in the real estate market. Maybe you would like to get a loan against your commercial property. But who really knows the value of a building in today's volatile environment? Bear in mind that an appraisal is just that - not an actual purchase offer. "The bubble that occurred in residential real estate also occurred in commercial real estate," points out McQuaig. That makes banks nervous.
A third reason is the economic challenge faced by banks themselves. It's simply tougher for bankers to make money today. "With interest rates at a 40 to 50 year low, banks are not getting as much back on their loans," says McDermott. "So you have the perfect storm of circumstances: an extremely low priced product, a difficult economic environment, and at the same time a higher degree of regulatory scrutiny."
It all comes together to raise the stakes for any lending activity. Banks just tend to avoid any loans that might incur a high level of risk. "Many business owners don't fully understand that banks are not venture capitalists," says McDermott. "Banks are not lending their own money, but that of their depositors. And because interest rates are so low, banks get low returns from their lending operations. As a result, they will only take on low-risk projects."
Maybe the shift of emphasis from hard assets to cash flow makes sense to the lending banks, but for business owners it can be catastrophic when financing falls through at loan renewal time.
"You can have trouble renewing a loan backed by a building, even if you have dutifully made your payments on time," says McQuaig. "Maybe your business is cruising along okay, but then you hit your three- or five-year renewal point and your bank calls your loan. And then you cannot get financing elsewhere."
Why should a bank call your loan? One reason is that many banks have weak balance sheets. This can create the need to restructure their own portfolios in ways that leave old customers thrashing for lifelines. In the current economic environment banks are often merged and staffs reformed, and your long time banking contact may disappear. "Suppose you have some one-year maturity loans that you refinance every 12 months," poses McQuaig. "Who will you be talking with next year? Maybe nobody. Or maybe to the FDIC, which is only interested in liquidating loans."
Often a bank that is in trouble will be under an order of the comptroller of the currency to reduce its commercial loans. In such a case, come renewal time you may discover you need to pay off your loan in 30 days. That is not very long to get your building appraised and to find a new bank. And a new bank may well think something is tainted - even if your loss of a credit line is your current bank's fault.
Your credit line may disappear even before the maturity date of your debt, points out McQuaig. "A bank is bound to its agreements as long as you meet your covenants. For example, you may need to maintain a free cash flow ration of 1.5 to one. That means that if you have a $10,000 monthly loan payment, you need $15,000 monthly in free cash flow."
But what happens if one of your largest customers goes broke and doesn't pay you? "Suppose your business operates on a 10 percent income margin," posits McQuaig. "If a customer fails to pay a $50,000 bill, it will take you $500,000 in sales to recover that amount and maintain the same cash flow. If your ratio suddenly changes for the worse, the bank may call its loans."
Another possibility is that your bank decides to appraise your property. "If the appraisal brings you out of compliance with your covenant, the bank may call your loan," says McQuaig. None of these possibilities is out of the question, he adds. "A bank that wants to get out of a loan will look for a way to do so, and that can come as a shock."