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What Your Banker Looks For When You Ask for Credit |
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You’ve been hearing it for over a year now, there is a credit crisis. The news is full of stories of businesses unable to obtain credit, yet banks say that they are lending money. But to whom? The answer is to qualified borrowers. So what makes a borrower creditworthy? Lenders look at four primary items to evaluate creditworthiness which are commonly referred to as the ‘Four C’s’. The first C is ‘Cash flow’. Cash flow is the most important of the Cs since it is the primary source of debt repayment. Cash flow is assessed in both quantity and quality. Creditors look for adequate cash flow to service the debt in both good times and in bad. They want to know that you can service the debt even when business is down.
So when they evaluate your credit application, they will build in a safety margin in assessing your capacity to service the debt. So what is that margin? Who knows? Each bank has its own secret formula. But you should be prepared with your own assessment of your cash flow and be able to see if it will support debt when business is down. Cash flow quality can be viewed as the risk attached to your servicing the debt. Consistent cash flow from period to period means that there a not large swings in the cash generated or consumed. A major way to improve cash flow consistency is to have a diverse revenue stream where your sales are to a variety of customers and industries. C number two is ‘Credit’. Credit refers to the amount of debt there is in a business relative to the assets. What a lender looks for is that the business owners have invested in the business. This is most often measured by the debt/equity ratio. A lender wants you to have skin in the game. After all, if you are not willing to bear a significant risk in the businesses success, why should they. ‘Collateral’ is the third C. All secured loans are secured by some form of collateral. Most collateral is in the form of tangible property.
The type of collateral often varies with the type of credit extended. Liquid assets such as accounts receivable are often the collateral for lines of credit. Fixed assets such as real estate and equipment are often used for mortgages and term loans.
While lenders want collateral, it must be remembered that it is the secondary form of repayment for them. A bank does not want to own your building or have to go out and collect on your receivables. Last but not least, ‘Character’ is C number four. A creditor wants to lend to someone they trust. Trust is built upon relationships.
This is why commercial lenders are often called Relationship Managers. An aspect of both Character and Credit is the businesses (and personal) credit history. In the current lending environment, a smaller business will not get a loan without the personal guarantee of the owners. A personal guarantee represents the third means of repayment for the lender.
So, a lender wants to lend to a business owner with high personal character and a solid personal financial position with a strong credit history. So that you are not surprised when a lender approves a deal, they add a fifth C; ‘Conditions’. These are the covenants and restrictions that a borrower must adhere to if they want the money.
So, when you are in need of financing, remember the four Cs. Better yet, remember and plan to make sure you have the four Cs right, before you need a loan. The old saying that a banker only wants to lend you money when you don’t need it is often true. Prepare for and arrange financing before you actually need it.
Ray Miller is a Partner with B2B CFO®, the nation’s largest Chief Financial Officer firm serving emerging and mid-market companies with revenues up to $75 million. B2B CFO® works with companies that want to increase cash, profitability, sales and company value. Contact Ray Miller at 908-684-5411 or rmiller@b2bcfo.com. Visit the firm’s website to view his bio and other information at www.b2bcfo.com.
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