Here’s some good news for anyone seeking a loan: Banks are showing new signs of vigor after a long period of infirmity following the financial meltdown of 2008. “Bank profits are up, and most have paid back the money they received under the federal Troubled Assets Relief Program (TARP),” says Bill McDermott, CEO of Atlanta-based McDermott Financial Solutions (www.mcdfs.com).
A healthier banking sector couldn’t come at a better time. Many small businesses, spurred by improving economic conditions, are starting to gear up for the kind of aggressive growth that requires outside financing. “Business owners are starting to spread their wings,” says John McQuaig, managing partner of McQuaig & Welk, the Wenatchee, Wash.,-based management consulting firm (mcqw.com). “There is more demand for expansion and equipment loans than there has been at any time since the Great Recession.”
Expansion’s not the only reason to court bankers. Acquisitions of other businesses require financing. So do sale-leasebacks. Finally, the time has never been better for lessening interest payments by restructuring loans on more favorable terms. “Interest rates have continued to settle downward to a degree we did not expect,” says McQuaig. “There is still a good window to get long term debt financed at lower rates.”
If the general climate for loans has turned sunnier, getting to “yes” is no cakewalk. Even an applicant with healthy financial papers and a cogent business plan can face rejection. “The typical small business owner may not feel the lending climate has really changed that much,” admits McDermott.
What gives? Part of the problem is that the economy, while showing improvement, is doing so only slowly. Banks, therefore, are very cautious about lending money to businesses with overly optimistic revenue increases. Furthermore, federal banking regulations introduced after the Great Recession often act as roadblocks to loans that might otherwise be made. Marry that fact with a persistent low interest rate environment and it’s little wonder many loan officers sit on their hands (See sidebar, “What’s Holding Banks Back?”).
So how do you cut through the financing thicket? You can ease the way by making sure you produce the financials the banks desire. “Historically banks have looked at the five Cs of credit,” says McDermott. “Those are character, collateral, cash flow, credit and conditions (economic).”
In the years prior to the Great Recession many banks were willing to make loans with one or two of the Cs missing. They would often just look at collateral such as commercial buildings. Not so today. Bankers are likely to look at all five Cs. Cash flow, in particular, has taken a front seat. Why? A desire to reduce the risk of default. “Cash flow pays loans back,” says McDermott. “Very often banks will require that a business maintain cash flow of 120 percent of the monthly payment amounts. Some banks go to 130 percent, a more conservative benchmark.” It’s not unusual today for a bank to ask for cash flow reports for the previous 18 months before granting a loan.
Cash flow requirements may become even more conservative because of widespread expectations that interest rates are about to start rising again. Says McQuaig: “The bottom line is you have to have as much cash flow as you can.”
Read your covenants
Cash flow (and other) requirements are defined in the “covenants” that appear in your loan document. Overlooking them can be costly. “Covenant compliance is very important to banks,” says McDermott. “Suppose a bank extends a line of credit dependent on the borrower maintaining a cash flow of 120 percent of monthly payments. If the business loses money or the cash flow is less than the required level then the bank may declare a loan default, liquidate collateral, and refuse to extend the line of credit. That means the borrower has to find financing elsewhere.”
Even if the bank does not immediately call your loan it may require drastic changes to your operations to better secure the cash it has at risk. “The bank may issue a ‘forbearance agreement’ which extends the line of credit in exchange for something,” says McDermott. “That something might be a plan that shows how you will turn around the business. That might involve a move into a new market, the introduction of a new product, or the selling of inventory and real estate to skinny down your company to its core profitable business.”
Keep in mind that maintaining the required cash flow can mean adjusting your selling prices. “Many small businesses don’t have margins set properly, so they are not making the money they need to cover their loans,” says Marilyn J. Holt, a Poulsbo, Wash.,-based management consultant (holtcapital.com) “That’s where they get into trouble.”
Seasonal or cyclical businesses (such as retailers) have a special problem, says Holt. They need money to invest in materials or inventory for the next sales season. That kind of investment can be looked down upon by banks which are nervous that the business will not make the sales needed to justify the investment.
Pick your target
It may be time to reassess the banks you are approaching. Even in the best of times the larger banks with household names—the ones you are likely to think of first when seeking loans—are less than ideal partners for the small enterprise. McQuaig says that many such banks tend to be interested only in larger clients requiring over $50 million in financing. “Bigger banks are doing big stuff,” he says. “If you are not a ‘big stuff’ borrower I would not use them.”
One problem is that the big banks tend to shortchange the small borrower when it comes to financial guidance. “Business owners are not getting the banking advice they need from large banks,” says McDermott. “There is a real void in knowledge out there.” The reason: “There was a point in time twenty or so years ago when many banks stopped providing credit training for their personnel. Instead, they consolidated credit knowledge into a small group of people. Bankers in general became sales people.”
The lack of an easily tapped knowledge bank causes problems for business owners in general, and especially for those without a financial background. “Small business owners are turning for financial advice to their CPAs and attorneys,” says McDermott. “But those people do not have experience as bankers.”
As a result of these issues, smaller banks are more attractive to small business. “Community and local banks are doing well financially, have no or fewer regulatory issues, and are also more open to making small business loans,” says Holt.
The right community bank will take the time and effort to understand your business requirements and take care of your needs on a long term basis. But do your groundwork first. “Start by figuring out your business vision and be able to articulate it,” says McQuaig. “Then make sure your bank understands it. Build a relationship with one or two bankers who know what you are doing and what you are trying to achieve. If you make your vision clear to them they can help you get in position to accomplish your mission.”
Speaking of smaller financial institutions, include credit unions on your short list. But choose carefully. “Credit unions are relatively new to commercial lending,” says McQuaig. “Make sure you are with one that has a true commitment to business lending, and is in it for the long term.” One particular pitfall, says McQuaig: “Credit unions are often transaction oriented. They might be interested in financing an office building, but might not be interested in financing a line of credit or buying accounts receivable.” That can be bad, because it’s usually more favorable for a business to consolidate all of its banking activity under one institutional roof.
Because smaller banks can be friendlier to small businesses they are often more approachable. That can make a difference. “When I go into my local community bank, everyone knows me because I see them every week,” says Holt, who runs a small business in addition to her consulting gigs. “If there’s a new person in the bank I make a point to go over and look at their badge and then greet them by name, even though I was planning to see someone else. I also say goodbye to that person when I leave.”
The result is that everyone in the bank calls Holt by her first name. That kind of personal touch, she says, can help resolve business issues. “One of our business checks recently went astray. The vendor said the check had not been received, but the bank reported it as cashed. I didn’t want to pay the vendor a second time. When I reported the problem to my bank, several people began to work on the problem. You will not get that kind of attention at the bigger banks.”
Vet your lender
While smaller banks may be more approachable, they are also more prone to fail. Perform some due diligence when checking out a new bank. “Most financial information is available on line from the banks themselves,” says Holt. “But you should also go to the site of your state banking commission. You can look up the records on every bank operating in your state, including their ratings from S&P, D&B and other agencies.”
Is your prospective bank struggling with capital adequacy problems? (That is, are its cash reserves insufficient to satisfy new and more stringent Federal regulations?) If so, it may be looking to trim its assets to get its balance sheet in line. “A bank that is undercapitalized may not renew loans that it otherwise would,” says McDermott.
Are there merger rumors about? Problems can arise when a bank is acquired by another that wants to exit your industry. Just one more reason why your loan might not be renewed come maturity.
You can also get a bead on the quality of the institution by personal visits. “Walk in and talk with the bankers,” says Holt. Chat with the bank or branch managers and see what they are like.” Do they take a real interest in your business?
As for getting references, a prospective bank will not give you the names of their current business customers because that is a violation of privacy. But you can ask for feedback from fellow members of organizations to which you belong, such as the Chamber of Commerce and Rotary.
“Ask other businesses if the people at the prospective bank seem to be knowledgeable about banking issues,” suggests Holt. “If not, the individuals might have been hired as sales people to recruit business loans.” That can come back to haunt you later, when an overextended bank pulls its loans and leaves your business high and dry.