Many business experts believe that loosening credit to small businesses should be a top priority for banks and policymakers. In my opinion making credit accessible to sound businesses is crucial to our economy and so should be front and center among our policy challenges.
In general, banks feel they are under pressure to be very conservative in their credit underwriting to appease the bank regulators. This mindset does not result in the maximization of new loans granted.
Regulators have stated that financial institutions that engage in prudent small business lending after performing a comprehensive review of a borrower’s financial condition will not be subject to supervisory criticism for small business loans made on that basis.
That is a powerful statement. Thus, to be prudent, a bank must perform a “comprehensive review” of a borrower’s financial condition, an analysis that according to regulators would lead to sound business loans instead of risky ones.
The following are generally what commercial banks look at when conducting a “comprehensive review” of a small business loan applicant.
Leverage ratio
A balance sheet ratio derived by dividing total business liabilities (including the proposed loan) by total business equity. Usually banks like to see this ratio at no greater than 3.00 to 1.
Profitability trends
A letter grading scale is helpful in explaining this category. If your business has been profitable three years in a row, the bank would rate your business an “A.” Two out of three years would give you a “B” or “C.” One out of three a “D,” and three consecutive years of losses an “F.” Depreciation and amortizations is added back to the bottom line in evaluating profitability.
Management team
While the first two areas are based on numbers, this area is a judgment call on the part of banks. Here banks are looking for hands-on experience, competency and depth in the management team. If your team has been through a previous down turn in the economy and prevailed that is a real plus.
Collateral
Must be available, relatively liquid, and the nature of the asset must lend itself to being appraised by an outside third party. Banks will rate you higher here based on lower loan to collateral values. Lower LTVs are perceived as lower risk.
Cash flow/debt service
A balance sheet and income statement ratio derived by dividing net income + depreciation/amortization + interest expense by principal payments on existing and proposed loans + interest expense. Most banks like to see this ratio at a minimum of 1.20 to 1.00. The higher this projected ratio, the better.
Industry trends
Banks look at what industry you are operating in and make a determination as whether they consider your industry to be high, medium or low risk based on current trends.
Personal guarantors
For privately-owned businesses, most banks will require that the majority owners personally guarantee loans made to their business. Banks rate guarantors based on their amount of net worth (exclusive of their ownership interest in their business), liquidity and personal credit history.
Small business owners use these bullet point guides as a resource when applying for a loan. If at all possible try to shore up any weak aspects of your business. Banks want to approve your loan request if you take the steps to avoid being considered high risk.