It’s not easy to persuade banks to loan money to small or medium-sized businesses in Canada, especially in these turbulent times following the sub-prime mortgage crisis and meltdown in the asset-backed commercial paper market.
The global banking system was prepared to write down more than $100 billion in 2007 alone, the Associated Press reports. It’s safe to say that this prolonged period of tightening liquidity won’t make it any simpler for a business to obtain or renew financing.
Seasoned commercial bankers are now pointing to a serious “triple threat” to business borrowers:
• Increased interest rates, as banks’ own borrowing costs have risen in the wake of the funding crisis.
• Potential for lending “caps” being imposed in sectors like real estate, retail, and manufacturing. Such portfolio segments get “filled up” leading to restrictive lending practices and requiring business owners to “shop around” for funding.
• Tightened credit adjudication, as banks become increasingly concerned with the U.S. recession, record oil prices, weakened manufacturing sector in eastern Canada, global credit crunch, and bailouts of once revered financial institutions like Bear Sterns.
Given this gloomy backdrop, business owners need to understand that securing the right financing deal can make the difference between growing, stagnating, or failing. Here, then, are some pragmatic guidelines and insights, aimed at business owners and managers on getting the bank to say yes.
Developing the correct rationale
To commence the loan application process, there are four fundamental questions that need to be answered:
1) The purpose — Does the purpose make sense and is it consistent with the company’s growth strategies? Is the borrower looking for an operating credit (to finance short-term working capital needs) or a term loan (to fund longer-term needs like capital expenditures)?
2) The amount — Is the amount sufficient and can the dollar amount that is being requested be justified? Many companies either shoot too high or too low.
3) Repayment — From what source will the loan be repaid and over what time period? The bank needs to have a clear fix on the client’s ability to generate sufficient cash from their operations on a sustained basis.
4) Security — What collateral is available? How tangible are the assets that are being secured, say a house mortgage versus an inter-company guarantee? The bank will always want a “second way out” — cash flow from company operations is the primary one, followed by collateralized assets owned by the company and/or the shareholders.
Understanding the process
The next step is to get a fix on the loan application process. While practices vary, banks usually separate business borrowing by the amount to be borrowed: $100,000 to $500,000 for the small business sector, followed by “mid-market” borrowing requirements in the $500,000 to $10 million range. Amounts less than $100,000 are normally funded by a personal loan to the company owners with the money injected into the business by way of shareholder loans. Expect loans up to the $10 million threshold to be handled by the local branch or regional lending team. Amounts over that usually go to a specialized corporate banking team or division, probably in Calgary or Toronto.
Banks have varying lending appetites depending on industry sector and driven by guidelines based on either economic cycles and/or recent loan loss experience. For example, some banks have more stringent farm lending practices based upon recent adverse commodity prices movements. Others have tighter collateral requirements when lending to the hospitality industry due to recent loan defaults in that sector.
Location is also another factor. A company based in a large urban area typically has a smoother ride and gets prompt loan approvals compared to an enterprise operating in a more remote or rural location due to concerns around sustainable demand for the company’s products or services.
A final critical issue is your local banker. If a business owner has developed a close, trusting relationship, every effort should be made to retain this important linkage. A banker, who has enthusiastically championed the client’s loan applications, assuming more of a “trusted advisor” role, is a key success factor in a company’s evolution. Even if increased borrowing leads to a company’s file being transferred to a more senior lending unit, the local banking relationship should be retained wherever possible.
Assessing the commercial risk
Having developed a solid rationale for a borrowing request, allied with an understanding of the required loan application process, the company owner’s next step is to be aware of the risk identification and assessment process that the bank will undertake. While each bank’s risk assessment process can vary, inevitably they all cover the following key areas. Here are some typical questions that will be asked:
1) Company strategy — Is it based on cost/ price leadership, differentiation of products/services, or a focus on distinctive market segments? Is the company able to identify key success factors and do they have a fix on the competitive environment within their sector?
2) Market potential — What is the company’s market size and which market segments have been developed? Is there over-reliance on a few large clients or a well-spread, balanced clientele? Does it rely on one or a few suppliers or distributors? How stable is market demand for the product or service and how vulnerable are they to competition.
3) Infrastructure and operations — Consider company-owned fixed assets in terms of location, condition, and adequacy. Are premises owned or leased? Is adequate insurance in place? Are there any environmental issues? Assess the price stability and availability of supplies, materials, and labour. If applicable, review inventory in terms of mix, location, condition, and ability to liquidate.
4) Financial performance — How reliable and current are the company’s year-end financial statements and have they been prepared by an accredited accounting firm? Are there any “off balance sheet” issues to consider, for example, an appraisal surplus in company-owned property? Is there adequate working capital and acceptable cash-driver performance demonstrated by appropriate inventory turnover, accounts-payable settlement, and accounts-receivable collection ratios? Is there an adequate balance between debt and equity, along with sufficient cash flow to support expanding sales?
5) Management capability — Are shareholdings held on an amicable basis or is there potential for conflict? Is a buy-sell agreement (along with an appropriate shot-gun clause) in place? Is there an ability to inject funds from sources outside the company? Do owner and managers have the skills to manage daily operations? Have expansion plans been carefully conceived and are they in line with working capital, equity base, and earnings capacity? Have continuity and succession issues been addressed? Is there a clearly defined chain of command? Has the next generation of management been identified?
In reviewing these five risk-assessment “lenses,” a question that often arises is which is the most important? They all play a key role in developing a balanced view of corporate health, but management capability is the critical area. A company may have a well-developed growth strategy, strong market profile, solid infrastructure and operations, and steady historical financial performance. Yet, if there are doubts about management, this is always a showstopper. At the end of the d
ay, seasoned bankers always bet on the jockey as opposed to the horse.
If the company, guided by advisors, is able to present a summary of operations framed by the above five “lenses,” they will be well on the way to a successful financing application.
The banks have their own due diligence procedures, after completing a risk assessment, to ensure there are no hidden surprises. Some typical due diligence questions posed by the bank are:
How well do we know the individual shareholders? Are the key players actively or passively involved? Any there any significant family relationship issues pending, like divorce, ill health, personal financial difficulties, etc?
Has there been a recent tour of company operations, along with introductions to senior management? Can we confirm the reputation of the accounting firm and partner signing year-end statements? Are there any contingent liabilities (guarantees to other related companies) or unfunded liabilities, such as pension contributions? Is there anecdotal evidence of the company’s depth of reputation in the marketplace and with key suppliers? From a legal standpoint, has there been past or pending litigation against the company? Are there any patent or copyright protection issues that need to be addressed?
Understanding the steps will lead to a more time-efficient and successful experience for owner-managers and their advisors.