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The Relationship Between Financial Management and Loan Underwriting

Posted on October 28th, 2018

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In my previous article, “Securing a Small Business Loan Revisited,” I went over the phases of approaching a bank for a small business loan, wherein I made this observation: “In recent articles I’ve also talked about the importance of using an appropriate method of accounting, budgeting, and strategic financial planning. The reasons these activities are important are twofold: 1) managing your business’ growth, profitability, and cash flow; and 2) obtaining outside financing as and when needed.  This article revisits some earlier articles I’ve written on the topic of obtaining bank financing, but the two objectives are very closely intertwined, as banks first and foremost want to know if you are addressing reason number 1.

What I was referring to above was a section on the topic of Understanding the Lender’s Underwriting Criteria from another article, that concludes with this statement:

“Even a brief examination of these points suggests the need for you to do your homework before making a loan request, because an experienced loan officer will ask probing questions about each of them. Failure to anticipate these questions or providing unacceptable answers is damaging evidence that you may not completely understand the business and/or are incapable of planning for your firm’s needs.” (Securing a Small Business Loan – Part III: the Application)

The point is, the lender wants to know how you manage your business financially, because that has a direct bearing on if and how your loan can be repaid.  So exactly what ARE some of the things (experienced) lenders are looking at, and why:

  • Profitability:  A business that has historically lost money, and is continuing to lose money, is on its way out of business.  The lender’s loan cannot be repaid, nor can it prevent the business from failing in the long run.
  • Debt Service Coverage:  The adequacy of existing (NOT projected) profit and cash flow to fund both existing and proposed loan payments.
  • Balance Sheet Leverage:  The amount of debt in the company in relation to its net worth. The more debt the company has, the more susceptible it is to swings in sales, profit, and cash flow, particularly for a company that has thin margins to begin with.
  • Liquidity and Turnover Ratios:  The ability of the company to fund day-to-day operations through internally generated cash flow.  A negative net working capital position can jeopardize the business’ ability to meet payroll, pay suppliers when due, make loan payments on time, and fund many other short-term cash needs.
  • Sales Growth:  The faster the business’ growth, the more cash flow that is consumed by “permanent” increases in working capital.  This is due to the cash required to support the related increases in accounts receivable, inventory, labor costs, and so on, that far exceed the company’s internally generated profit and cash flow – until the growth levels off.  This type of funding need can bankrupt a company if it goes unchecked, and most “traditional” banks are usually not staffed and equipped to provide this specialized type of financing.
  • Funds Management:  The proper matching of sources and uses of funds. For example, the funding of major capital expenditures out of cash flow, or with short-term debt, can severely cripple a business financially, the same as poor liquidity can as discussed above.

If you need assistance in better understanding the above issues, see below articles for more information.  Or, if you need help with working with a lender, just give us a call.

Related Articles:

Securing a Small Business Loan: Winging It

The Effect of Operating Losses On Cash Flow

The Difference Your Method of Accounting Can Make

The Ratios: Which Are the Most Important?

The Relationship Between Turnover Ratios and Cash Flow

The Effect of Sales Growth On Cash Flow

The Effect of Funding Fixed Assets Out of Cash Flow

Case Study: The Risk of Sales Concentrations


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