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."
Get Ahead of the Curve
Given that a lending bank will likely analyze the historical cash flow of your business, it's smart to be proactive with your own analysis.
"Reach out to your banker right away if you think you are going to run afoul of one of your loan covenants," says Linda Keith, a CPA based in Olympia, Wash., with a niche practice in lender credit training. "Do this before the banker spots the problem. Make it clear that you pay attention and that you have a plan to resolve the issue."
And make sure your bank is aware of how well your business is doing. "If your company has done well during the recession, don't assume the banker knows it," says Keith. "The assumption may be that you are struggling when you are not. Send up the flag and the fireworks. Invite them to come see your business; give them a tour."
You may also run into a related problem: Your recovery from the recession is not yet reflected in your three most recent tax returns - the standard documents perused by bankers.
"Even if revenues have rebounded, business owners may have a hard time convincing bankers who often rely on outdated financial data," says Keith. What to do? "You have to prove in some way that business is up. Bring the good news to your banker in the form of documents such as signed contracts and updated financial statements. You might even provide a trade association article talking about an upturn in your industry."
But just how much leeway does a bank have when getting to "yes"? Regulators, after all, are still very interested in how banks are qualifying borrowers. Even a long-time relationship and great year-to-date financial documents might not support a loan if federal and state regulators won't allow your bank flexibility in terms of consideration of documents beyond the traditional three years of tax returns.
"The regulatory environment is difficult and not always consistent," says Keith. "Yet, a bank with a strong capital ratio and which is not under scrutiny by the FDIC will have more flexibility."
Small Is Good
As the above comments suggest, it's in your interest to assess the financial strength of your primary banking institution. For that matter, have a second bank in your pocket - You may need it when loan renewal time comes around.
That second bank may well be a smaller one. "As banks have become bigger in recent years, they have put fewer people on the ground and have become less helpful to business customers," says Marilyn J. Holt, a Seattle-based management consultant. "Many are no longer interested in handling little loans. It's a huge challenge for the small business person."
Not only are smaller banks friendlier to small businesses, but they may well lend when larger banks will not. "Many community banks actually have too many commercial real estate loans and want to rebalance their portfolio by making business loans," says Keith. "They have money to lend if you can demonstrate your business operations will provide adequate cash flow."
And don't overlook another source: "Many credit unions are getting into `member business lending, as well" says Keith. "Many are in very good capital positions." And while credit unions are known for smaller loans, they can participate with each other to make larger ones.
Smaller banks and credit unions are less likely than large banks to rely on the automatic credit scoring that can kick out applications from many companies. For those prospective borrowers that don't score high, they may be more likely to sit down with the small business owner and consider all of the financial documents and other factors.
Bonus tip: "Utilize your smaller bank for fee-based services such as payroll processing," says Holt. And let them know how you are supporting them. "When you emphasize to the bank that you are making yourself part of their profit picture, that does help you."
On the Edge
Whatever your funding source, make a good impression by demonstrating a personal understanding of your business finances, advises Keith. "Are you one of the many business owners who are not real strong on the financial side of your business? Seek some continuing education in the topic. Look for workshops at your local community college, or online courses."
And communicate with your banker. "Relationship banking goes both ways," says Keith. "A good banker maintains a relationship with you, but you also need to take the initiative. Get in touch early if something is about to happen that may be perceived as negative."
Being proactive will make you stand out, adds Keith. "Later, when it's time for the banker to go to bat for you with a loan committee, he or she can say that you maintain good business practices and called ahead of time when something was wrong. That can be the difference between `no' and `yes'."