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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

 


Securing a Small Business Loan Revisited

Posted on October 22nd, 2018

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

From time to time I receive emergency requests from clients who need to provide financial information to a bank, but they are months behind getting us the information we need to complete their financial statements.  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:

Step 1: Establishing a Banking Relationship

At some point, most small businesses owners will visit a bank or other lending institution to borrow money. Understanding what your bank wants, and how to properly approach them, can mean the difference between getting your money for expansion and having to scrape through finding cash from other sources. Unfortunately, many business owners fall victim to several common, but potentially destructive myths regarding financing, such as:

  • Lenders are eager to provide money to small businesses.
  • Banks are willing sources of financing for start-up businesses.
  • When it comes to seeking money, the company speaks for itself.
  • A bank, is a bank, is a bank, and all banks are the same.
  • Banks, especially large ones, do not need and really do not want the business of a small firm. Read More

Step 2: Positioning

Walking into a bank and talking to a loan officer will always be something of a stressful situation.  Preparation for and thorough understanding of their evaluation process is essential to minimize the stressful variables and optimize your potential to qualify for the funding you seek.  Read More

Step 3: The Application

Lending is the essence of the banking business and making mutually beneficial loans is as important to the success of the bank as it is to the small business. This means that understanding what information a loan officer seeks–and providing the evidence required to ease normal banking concerns–is the most effective approach to getting what is needed by the lender.  Read More

Related Articles

Securing a Small Business Loan – Winging It

The Effect of Operating Losses on Cash Flow

Larry’s Debt Repayment Strategies, Inc.

Cash Flow Expressed as Asset-Based Borrowing Availability

 

 

 


The Difference Your Method of Accounting Can Make #2

Posted on July 22nd, 2018

Jack Kern
Owner /President
Outsourced Accounting Department, Inc.

In my first article on this topic (“The Difference Your Method of Accounting Can Make), I talked about a private ambulance company that was able to obtain significant bank financing, improve receivable collections and cash flow, and solve an employee turnover problem while simultaneously reducing labor costs, all by simply using the proper accounting method to evaluate their true financial situation. In this article I will talk about what can happen when the wrong accounting method is used.

To provide a little background, over the past fifteen to twenty years, as banks have gotten bigger and bigger, the banking industry has gotten away from requiring financial statements prepared in accordance with Generally Accepted Accounting Principles (“GAAP”), the underlying premise of which is to “match” revenues with their related costs (Accrual Accounting).  Instead, for its own convenience, the banking industry has gone to using tax returns, credit scoring, and what’s called a “global, debt service coverage ratio” to measure a small business’ ability to repay a loan. Basically, this means that if the company’s and its owner’s combined tax returns show a lot of income, and the owner has a high credit score, you’re in! If not, you’re out!

The problem with this loan underwriting approach is that while a business owner can utilize legitimate tax methods to reduce his or her business income for tax purposes, using this same information may very well work against them when applying for a business loan.  And since banks no longer require GAAP financial statements for “small” businesses, owners don’t request them from their CPA firm because they don’t understand why they need them, and they don’t want to pay for them.

A case in point: A while back, a client of ours found out what happens when your bank relies on your tax return to support your line of credit.  As a matter of practice, our firm always prepares the company’s internal financial statements based on GAAP, and then at year-end, if our affiliated CPA firm also prepares their tax return, they also prepare GAAP financial statements to accompany them.  However, in this case, the client used another CPA firm who simply took our financials and converted them to cash basis for tax purposes, and a tax return was all the bank required to support the company’s $500,000 line of credit.

For the record, we did strongly recommend to their CPA that he also prepare compiled financial statements in accordance with GAAP using our internal numbers.  However, as his firm was strictly focused on tax preparation services, he told our mutual client that he knew the bank’s management, and that he didn’t need GAAP statements.  Then the CPA made some major accounting adjustments for tax purposes that made it appear that the company had distributed a large amount of money to the owner all in one year, and paid off a stockholder loan that was subordinated to the bank’s loan.  In fact neither of these were true, and compounding the problem, this was at a time when the company’s “taxable income” (cash basis) was already way down.  The outcome?  The bank panicked and terminated the company’s half million dollar line.

Sadly, the owner had already taken corrective action based on the internal numbers we provided to him, which painted a true picture of what was going on in his business and reflected the measures he had taken.  Had the proper financial information also been provided by their CPA on an accrual basis, it might have instilled more confidence on the part of the bank’s management in the business owner, and perhaps the outcome would not have been quite so drastic.  But instead, the bank had no idea what was really going on in the business, and this is what banks do when they don’t know what’s going on.  Lesson learned – the hard way!

Related Articles:

Profit vs. Taxable Income

Profit vs. Cash Flow Made Easy

Securing a Small Business Loan – Part II: Positioning

 

 

 


The Difference Your Method of Accounting Can Make

Posted on July 16th, 2018

Jack Kern
Owner /President
Outsourced Accounting Department, Inc.

A while back I was doing some consulting for a well established private ambulance business that was having trouble getting approval for a $30,000 bank loan to buy two wheelchair transport vehicles. When I met with the owner, I asked to see the information that she gave to the bank. It was a classic situation I see with many small businesses – using cash-basis tax returns to provide to the bank, and in this case, with multiple entities and extensive intercompany transactions – such that no one could tell how the business was really doing by looking at the financials. At the same time, another business adviser was using this same information and advising her that she needed to let go of several paramedics — the life blood of her company, because her direct labor costs were “too high.” And ironically, management had been complaining about not being able to attract and retain quality employees from the local labor market.

The first thing we did was go back two fiscal years and recast the accounting on an accrual basis as I discussed in my recent article, “‘Profit’ vs. ‘Taxable Income‘,” and then combined the businesses for financial reporting purposes and eliminated the intercompany transactions. The end result revealed a company that exhibited strong earnings, but slowly turning accounts receivable creating a severe strain on cash flow. Moreover, when we compared our numbers to an industry study we obtained from the ambulance association, we discovered that as a percentage of revenues, our direct labor costs were actually lower, not higher than the industry average. At this point, we slammed on the brakes to review exactly what was going on.

Next, and perhaps most amazingly, we did a survey of the labor market and discovered that the company’s wage rates were far below the competition, which explained why the company was having a difficult time attracting and retaining quality employees. And the employees that were left had found ways to get around this by helping each other to abuse the company’s overtime policy. The remedy? We gave the employees an across-the-board pay raise and simultaneously cracked down on overtime abuses, and in the end, everyone came out ahead.

The final outcome of all of this was almost as unbelievable. First we wrote a business plan based on the revised numbers and obtained approval in only two weeks for bank financing totaling $650,000 (after previously having been declined for only $30,000 as stated above). This included a working capital line of credit, and a revolving line of credit to enable the company to purchase vehicles with just a phone call to the bank. We then looked into the accounts receivable turnover issue and discovered a production bottleneck in the billing department, which was quickly addressed and eliminated by bringing in temps to catch up our billing, and then addressing some personnel issues in the billing department.

None of this would have been possible without first correcting the company’s method of accounting and financial reporting. And by the way, the company’s method of reporting for tax purposes was left unchanged.

Related Articles

Profit vs. Taxable Income

The Role of Cost Accounting in Planning Your Business’ Success

What is the Basis of Accrual Accounting

Profit vs. Cash Flow Revisited: The Matching Principle

 

 

 

 

 


If We Build It, Will They Come?

Posted on July 30th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Recently I was asked by a banker to prepare a set of projections for a loan they were considering for one of their customers.  The owner wished to expand his facility to increase sales, and wanted to borrow a large amount of money to purchase a new building. From the point of view of the owner, the purpose of the projections was to create a business plan the banker asked for. However, from the point of view of the banker, the unspoken purpose of the projections was to determine if the business could repay the loan.

The banker’s real question here is, “What if” they DON’T come?  In other words, how solid are the revenue forecasts, and what happens if they don’t materialize? Can the business still absorb the payments on the new debt?  Understanding this, rather than jumping into creating a fluffy business plan, I put on my CFO hat and prepared a preliminary set of projections based on the business’ existing sales pattern and cash flow.

To illustrate, below is the sample company I’ve used in my last few articles. I’ve now made the assumption that the company borrows $1.8 million to buy a new building. It’s also assumed that its sales forecast for the rest of the current fiscal year is NOT affected by its expansion into its new facility (i.e., the owner’s expected sales growth from expansion into its new facility is based purely on speculation, NOT on any firm sales orders).

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Note first on the company’s P&L the doubling of interest expense from July on. Then look at the Cash Flow Statement.  For the entire year, the projected “Cash Flow After Debt Service” is a negative $252,000 (rounded).  Now, look below at the projected “Over Advance” of $241,000 for the year. Obviously, no bank is going to (knowingly) lend more money to a business to help it pay back its existing loan. So, all this number indicates is that without an immediate boost in sales, this deal does not work.

The question now is, does either the owner, OR the bank, want to risk that this game plan will not work?  Hint: First, banks are not investment houses, and therefore, are traditionally risk averse. So the only remaining question is, what is the owner willing to risk if he is “lucky” enough to get his loan approved?

Again, this is the importance of financial planning. It’s always best to think these things through before incurring the time and expense of going through a loan application process only to get your loan turned down, or worse yet, getting your loan approved only to end up in bankruptcy or out of business.

 

Related Articles:

Analyzing the Components of Cash Flow

Larry’s Debt Repayment Strategies, Inc.

Securing a Small Business Loan- Part I:  Establishing the Relationship

Securing a Small Business Loan – Part II:  Positioning

Securing a Small Business Loan Part III:  The Application

Financial Planning or Business Turnaround – Your Choice

Larry’s Fairy Godmother Strategies, Inc.


Cash Flow Expressed as Asset-Based Borrowing Availability

Posted on June 25th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In this article from Entrepreneur Magazine, “How Much Cash Do You Need for Your Business’s Safety Net?,” the author discusses the importance of maintaining sufficient liquidity in your business, or in other words, a cash reserve.

Then in another article from Entrepreneur Magazine, “The Ins and Outs of Cash Flow Statements,” the author explains the basics of what goes into creating a cash flow statement, including a link to this sample the author created in a spreadsheet: Sample – Traditional Cash Flow Statement.  Notice the bottom line of her sample is the ending “cash balance.”

But, what if your company is growing fast, and maintaining a sufficient cash reserve simply isn’t feasible. What then? Another way of looking at cash flow when you’re in a growth mode is in terms of borrowing availability against the company’s accounts receivable and inventory.  The difference here is that rather than forecasting a cash balance, you are now forecasting a cash requirement, and the ability to fund it externally through an outside lender, using the company’s accounts receivable and inventory as collateral.

Here’s what it looks like:

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Monthly Cash Flow Statement: The top section of this page is merely another cash flow format often used by banks to estimate a company’s ability to repay debt from cash flow.  It first converts accrual financial statements to a cash basis by calculating the changes in accounts receivable, inventory, accounts payable, and other miscellaneous balance sheet accounts to arrive at “Cash Available for Debt Service.”

Then, the general theory is, if “Cash Flow After Debt Service” is positive, the company is bankable.  If not, the company is growing too fast, or accounts receivable and/or inventory turnover is too slow, or maybe the company is losing money. In this sample, on average, a negative $113,488 (see report) is forecast for the year.  So, either an improvement in profitability or cash management is needed, or, some other type of non-bank lender or an equity infusion is more appropriate.

The next lines then reflect the “Financing and Investing Activities” (described in the “The Ins and Outs of Cash Flow Statements” article above).

Asset-Based Credit Facility – Borrowing Availability: Note in the Cash Flow Statement above the forecast ending cash balance of $10,000 through the end of the year.  This is just an assumed minimum balance the company desires to maintain in its bank account.

The next section then creates a whole different method of defining “Cash Reserves.” Instead of a cash balance, the above negative cash flow, or the “Change in Cash” after all operating, and long-term financing and investing activity, drives a funding requirement that is assumed to be funded under the company’s line of credit. The amount the company can actually borrow is then restricted to the percentage advance rate against receivables and inventory imposed by its lender, and whatever the lender considers to be “eligible” collateral, such as accounts receivable less than 60 or 90 days old, with a maximum advance on certain customers, inventory, and ultimately on the line of credit itself (i.e., the note amount).

In the above sample, the amount of borrowing availability is projected to be more than adequate to support the company’s cash requirements through the end of the projected period.  However, if circumstances change in the wrong direction, and certain major assumptions are altered, an “over-advance” may occur in the forecast.  If so, it’s an indication that either corrective action is needed internally, or alternative financing options must be explored to augment the company’s line of credit.  These “what-if”scenarios will be further demonstrated in future articles.                               

Related Articles:

Analyzing the Components of Cash Flow

The Effect of Sales Growth on Cash Flow

The Relationship Between Turnover Ratios and Cash Flow

Larry’s Funding Strategies, Inc.

Larry’s Debt Repayment Strategies, Inc.

 


Case Study: The Risk of Sales Concentrations

Posted on June 10th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In my previous article, “The Good News: Your Business is Growing – And That’s Also the Bad News,” I talked about how rapid sales growth can also create the need for large amounts of working capital to support it.  This need was subsequently met via an asset-based credit facility,  so the business was all set and off and running – that is, until the unexpected happened:  some major customer contracts for various reasons never materialized. And by this time, the company had already incurred large capital lease obligations on the equipment lines necessary to support its projected sales to these customers. In other words, its fixed costs had increased substantially, and therefore, its breakeven point of sales.

Thus, the company found itself in a major turnaround situation to fill its sales and production pipeline as quickly as possible to absorb its fixed costs (equipment leases).  Simultaneously, the company had exceeded its borrowing base on its asset-based credit facility, and was instructed by its lender to “stop writing checks immediately.” (And the almost humorous irony was, this company had recently been named by a local magazine as the “fasting growing company” in the region, precisely at a moment when it was on the verge of bankruptcy.)

Major steps were subsequently taken, including downsizing its employee staff while simultaneously negotiating extended credit terms from major suppliers, combined with revising its marketing strategy to target high volume contracts to absorb its fixed costs.  Then coincidentally, the company won a lucrative contract from an existing customer that both increased utilization of its new production line, and significantly boosted sales volume and cash flow. Another bullet dodged, right?  Yes – for a while. But the new problem now was that this customer had bet its future on a new product, one that quickly became obsolete with the advent of another product that quickly flooded the marketplace – the cell phone!  So suddenly what was the company’s saving grace was now becoming the final nail in its coffin.

The point is, as I discussed in my previous article, “Heading Off Business Failure,” one of the most common reasons I’ve observed as to how businesses get into financial trouble is a major sales concentration with one customer. If anything happens to that customer, even if their payments on accounts receivable just slow up a bit, it can have a major impact on your company’s cash flow, not to mention what happens to your company if they go out of business completely.

In the case of this company, what it really needed was to increase sales and diversify its customer base, and find an investor to either purchase or capitalize the business to buy time. However, its sales concentration with this one customer also created an insurmountable barrier for prospective investors who were valuing the company based on “earnings,” and its asset-based lender finally ran out of patience. Consequently, the company was ultimately forced into a distressed sales of its assets, leaving behind a major shortfall on its asset-based loan – to be repaid by the owner, personally.

Related articles:

7 Crucial Money Tips to Failure-Proof Your New Business

Larry’s Exit Strategies, Inc.

Larry’s Fairy Godmother Strategies, Inc.

The Role of Cost Accounting in Planning Your Business’ Success

 


Securing a Small Business Loan – “Winging It”

Posted on March 25th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

Now, having written several articles in this series on how to approach a lender, here’s what happens when you ignore these steps and rely on the lender to figure it out.

We have a client who operates two businesses that originally provided the same service, but were set up as two separate businesses for marketing purposes. Our client then (arbitrarily) writes checks and incurs credit card charges in each company often for the other company’s expenses, thus co-mingling expenses between the two companies. Consequently, one company could be showing a large profit, while the other is showing a loss. Then along the way, a new product line was introduced under one of the businesses requiring a substantial investment in inventory.

Each company’s tax return is prepared separately based on whatever the profit or loss is shown for that company (as it was impossible at that point to know to which company the various expenses actually belonged as they do the same thing). In the case of the company with the inventory, for tax purposes, they were allowed to deduct the entire amount of inventory purchases in the first year it was purchased.  This resulted in a large “book to tax adjustment” by the CPA who prepared the company’s tax return.

Because each of these companies is owned 100% by the same owners, our firm also prepares Combined Financial Statements for them every year based on their book financial statements which match inventory costs to their related revenues, and we then eliminate the inter-company transactions.  This is permissible under Generally Accepted Accounting Principles (“GAAP”), and provides a true picture of the two companies’ combined profit or loss as if it were one company.

Now, enter a prospective lender. Our client wishes to obtain a loan through one of the companies, so the lender requests tax returns for only that company, which in this case, was the one showing a tax loss. Then the lender requested some additional information, and we provided them with the combined financial statements.  These showed that on a combined basis, the two businesses (shown side by side along with all eliminating entries) were quite profitable. However, the lender only zeros in on the book loss of its prospective borrower which, for book purposes as described above, is much larger than what is reflected on its tax return.

First, suffice it to say this is NOT the way to establish a banking relationship, position your company, and apply for a loan, as discussed in Parts I, II, and III of this series. As a result, our client created mass confusion with the lender, resulting in his or her lack of trust and confidence in the numbers.  And our client’s reaction at this point?

But too late, the damage is done!  As I have discussed in numerous articles, bank lenders today are conditioned to rely only on tax returns to analyze the borrower’s profitability. This is utter nonsense, as tax returns are not designed for that purpose.  However, today’s lending officers don’t understand this, and often don’t care.  If the deal doesn’t fit their “cookie-cutter” guidelines it takes more time to analyze. And in today’s banking industry, large banks in particular don’t want to spend time underwriting “small” business loans, so they often just decline it and move on.

So what is the solution to all of this?  In today’s banking environment more than ever before, you have to be smarter than the lender, meaning anticipate whatever is going to cause him or her heartburn, and then deal with it right up front:

  • Do NOT spring tax returns on them showing losses and expect to get your loan approved. Lenders need to see a history of profitability which is necessary to repay their loan. (See Part III of this series regarding “Understanding the Lender’s Underwriting Criteria.”)
  • Instead, and assuming your business is profitable on a book basis, along with the tax returns, provide “compiled” or “reviewed financial” statements based on your book financials, and prepared by a CPA in accordance with GAAP on their letterhead. (See Part II of this series.)
  • If your CPA cannot or will not provide GAAP statements and focuses only on tax preparation, then find a CPA firm that does both tax and GAAP financial statements.
  • Explain the differences between your book and tax financials right up front – BEFORE he or she even begins their loan approval process. (See Part I of this series regarding “Build Rapport,” as well as Part II above).

As always, if you need assistance in dealing with prospective lenders, don’t hesitate to consult with your CPA or other financial professional, someone who can effectively communicate the above accounting issues to your lender,.

Related Articles:

Profit vs. Taxable Income

The Difference Your Method of Accounting Can Make

The Difference Your Method of Accounting Can Make #2

The Difference Between Your CPA and Controller: M1

 


Securing a Small Business Loan – Part III: The Application

Posted on March 19th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In Part II of this series I talked about the things a small business should do to prepare for applying for a loan. Now let’s get down to the specifics of the application itself.

Lending is the essence of the banking business and making mutually beneficial loans is as important to the success of the bank as it is to the small business. This means that understanding what information a loan officer seeks–and providing the evidence required to ease normal banking concerns–is the most effective approach to getting what is needed by the lender.

  1. Should you write a business plan?

In today’s banking industry, whether or not your bank requires a business plan depends on the size of your business and the loan amount, which in turn, determines the area of the bank that handles your loan request.  For smaller business loans, banks today may only require copies of your business and personal tax returns.

For larger loans, and/or certain types of lenders such as the SBA and private equity investors, a business plan is also advisable if not required. This document is the single most important planning activity that you can perform, and is advisable to do even if not required for your loan application.

A business plan is more than a device for getting financing; it is the vehicle that makes you examine, evaluate, and plan for all aspects of your business. A business plan’s existence proves to your banker that you are doing all the right activities. Once you’ve put the plan together, write a two-page executive summary. You’ll need it if you are asked to send “a quick write-up.”

The good news is, there are business plan software programs available on the market that will guide you through the whole process. But you may also wish to obtain the assistance with parts of it from an outside professional.

  1. Understanding the Lender’s Underwriting Criteria

The degree of analysis performed by the lender will vary based on the size of the bank and its lending culture, the size of the business, and the amount of the loan request.  In the larger banks today, the lending function is divided between “Business Banking” for smaller businesses, and “Corporate (or Commercial) Lending” for larger companies.  Exactly where this line is drawn is defined by each bank, and is largely a function of how much time they want to spend analyzing a business loan.  For smaller companies the approach may be to rely on tax returns, from which they compute what’s called a “Global Debt Service Coverage” ratio, and that you have an acceptable personal credit score and personal assets (such as your home), the concept being to treat the loan essentially as a consumer loan. For larger companies, banks will delve into much more detail on the business itself.

For purposes of this discussion, I will focus on what is required for larger companies, as the same principles apply to small businesses – regardless of whether the lender asks the questions.  (If you doubt this statement, or choose to ignore these principles, read here to see what the likely outcome will be: “Larry’s Fairy Godmother Strategies, Inc.”)

In general, a sound loan proposal or business plan should contain information that expands on the following points:

  • What is the specific purpose of the loan?
  • Exactly how much money is required? (“Larry’s Funding Strategies, Inc.”)
  • What is the exact source of repayment for the loan? (“Larry’s Debt Repayment Strategies, Inc.”)
  • What evidence is available to substantiate the assumptions that the expected source of repayment is reliable?
  • What alternative source of repayment is available if management’s plans fail?
  • What business or personal assets, or both, are available to collateralize the loan?
  • What evidence is available to substantiate the competence and ability of the management team?

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. (“Financial Planning, or Business Turnaround – Your Choice”).

  1. Next Step: The Lender’s Analysis

This is where Part II and Part III of this series come together.  As I have often said, the real value of accounting lies in the interpretation of the numbers. “Financial analysis” is a whole new academic subject, and I won’t attempt to cover it here.  But one ratio I consider to be the most meaningful when evaluating a business’ ability to repay a loan is Debt Service Coverage. There are several methods of computing this, but one ratio I feel is the most meaningful is:

Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”)
Total Principal + Interest Payments

 A ratio of less than 1 to 1 here is an indication that the business does not generate sufficient profit and cash flow to stand on its own and repay its debt. So regardless of what ratios the lender uses (which you may never know), you should compute this one yourself, as again, the alternative source of repayment (above) is this: “Larry’s Fairy Godmother Strategies, Inc.” (or in short, from your pocket, or worse, your home).

Most small business owners I’ve met know about their own business, but lack the financial expertise to explain their financials to lenders. If this describes you, don’t be shy about requesting assistance from a financial professional, including perhaps, an introduction to a lender that is best suited for your particular situation.

 

 


Securing a Small Business Loan – Part II: Positioning

Posted on March 11th, 2017

Jack Kern
Owner, President
Outsourced Accounting Department, Inc.

In P art I of this series, I talked about the importance of establishing a relationship with your bank long before you need a loan. In this article I will talk about selecting the right type of lender, and other things you should do in the years leading up to applying for a loan.

Which Type of Bank Or Other Lender is Suitable For My Situation?

Walking into a bank and talking to a loan officer will always be something of a stressful situation.  Preparation for and thorough understanding of their evaluation process is essential to minimize the stressful variables and optimize your potential to qualify for the funding you seek.

First, banks differ in the types of financing they make available, interest rates charged, willingness to accept risk, staff expertise, services offered, and in their attitude toward small business loans.  Selection of a bank is essentially limited to your choices from the local community. Typically, banks outside of your area of business are not as anxious to make loans to your firm because of the higher costs of checking credit and of collecting the loan in the event of default.  Furthermore, a bank will typically not make business loans to any size business unless a checking account or money market account is maintained at that institution. Ultimately your task is to find a business-oriented bank that will provide the financial assistance, expertise, and services your business requires now and is likely to require in the future.

But, also keep in mind that not all loan situations are even “bankable,” such as for instance if  your business is losing money, or growing too fast.  Or you may not have sufficient collateral to secure the loan with, such as in the case of rapid sales growth, where your only available collateral to secure the loan may be accounts receivable and inventory. These assets are not of much value to a bank unless they maintain absolute control over them, and most banks are not set up to manage this kind collateral.  Instead, a more specialized lender such as an “asset-based” (accounts receivable) lender or factor are more appropriate in these situations. Their rates are typically higher than bank rates, but if the loan enables your business to grow faster and do so profitably, the higher rate may be more than justified.

Finally, another source for very young businesses and /or which have insufficient collateral to secure a conventional bank loan, is the Small Business Administration (SBA).  Many banks offer this service wherein the SBA guarantees repayment of the bank’s loan in the event of default.

Before you apply for a loan here’s what you should do:

  1. Have an accountant prepare historical financial statements.

This is important. Many small businesses have only had their accountant prepare their tax returns every year, and their books are often maintained on that same tax basis, or worse hardly at all.  However, tax returns are not appropriate for measuring the true profitability of your business (see “The Difference Between your CPA and a Controller: M-1”). And by the time you are seeking a loan, the lender will most likely be looking for a historical (usually 3-year) trend of profitability, NOT tax losses (even though they are completely legitimate for tax purposes).

Also, internally generated statements are OK for interim monthly financial statements IF your books are maintained properly (“Small Businesses Need to Understand if They are Really Profitable“, “The Most Wonderful Time of the Year: Accounting Clean-Up Time,” and  “’Winging It’ in QuickBooks”).  But your bank will usually also want the comfort of knowing an independent CPA has verified the information at year-end, which, depending upon the size of the loan can take the form of “reviewed” or “audited” financial statements.  Compiled financial statements are NOT “verified” by your CPA, but are less expensive, better reflect your true profitability if based on accrual accounting, and often provide a comfort level to the lender almost as if they were verified, especially if they include footnotes.  Even though banks these days often only require tax returns, we always recommend to our clients that they also provide compiled financial statements based on Generally Accepted Accounting Principles (GAAP).  Then, you (or someone) must understand your financial statements, and be able to reconcile for the lender the differences between these statements and your tax return, and explain previous financial trends or hiccups.

  1. Line up references.

Your lender may want to talk to your suppliers, customers, potential partners or your team of professionals, among others. When a loan officer asks for permission to contact references, promptly answer with names and numbers; don’t leave him or her waiting for a week.

And it should be noted here that even if your bank ends up not being the appropriate lender for your loan situation, bankers often do maintain relationships with specialized lenders to whom they can refer you. So your banking relationship you’ve been building all of this time has not been in vain, as that level of trust is now transferable in the form of a reference.

In Part III of this series, I will talk about the specifics of what should go into a loan application.