If you're like most small business owners, you're finding it tougher than ever to negotiate with your bank. Loans are harder to come by. Fees are thicker on the ground. While the reluctance of banks to lend money can make it tough to fund operations, bank experts say the financing picture is not all gloom and doom.
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If you're like most small business owners, you're finding it tougher than ever to negotiate with your bank. Loans are harder to come by. Fees are thicker on the ground. While the reluctance of banks to lend money can make it tough to fund operations, bank experts say the financing picture is not all gloom and doom.
"The popular belief that banks are deliberately holding off on lending is a fallacy," says John McQuaig, managing partner of McQuaig & Welk, a Wenatchee, Wash.-based management consulting firm. "Banks are anxious to lend money, but they are unable to find enough good loan prospects."
Surprised? Maybe so, if you've just been turned down for a loan. Here's the problem: The definition of "good loan prospect" has undergone a fundamental change in this economic environment. "Loan decisions now are based on cash flow," McQuaig says.
That's fundamentally different from the lending paradigm a few years ago: "It used to be that banks would give you credit for the value of your inventory or your building or other hard assets," McQuaig says. "That's not the case today, unless you have good cash flow as well." Cash flow is often defined as net profit plus interest expense plus non-cash charges such as depreciation and amortization.
What's a good rate of cash flow? While the answer varies by bank and customer, there is a well-known rule of thumb: "There is an understood benchmark in the banking industry that a business must generate 120 percent of its total loan payments in cash flow," says Bill McDermott, CEO of Atlanta-based McDermott Financial Solutions. "So if you will be paying $100,000 a year in principal and interest, then your business had better generate $120,000 in cash flow."
Changing Times
Why have banks turned more conservative? One reason is a tough regulatory environment growing out of the crisis of 2008. "Regulators are putting the clamps down on banks, working overtime on reviewing loans," McQuaig says. "There is still a lot of fear on the regulatory side."
There's another reason: uncertainty in the real estate market. Maybe you would like to get a loan against your commercial property. But who really knows the value of a building in today's volatile environment? Bear in mind that an appraisal is just that-not an actual purchase offer. "The bubble that occurred in residential real estate also occurred in commercial real estate," McQuaig points out-and that makes banks nervous.
A third reason is the economic challenge faced by banks themselves: It's simply tougher for bankers to make money today. It all culminates in raising the stakes for any lending activity. Banks just tend to avoid any loans that might incur a high level of risk. "Many business owners don't fully understand that banks are not venture capitalists," McDermott says. "Banks are not lending their own money but that of their depositors. And because interest rates are so low, banks get low returns from their lending operations. As a result, they will only take on low-risk projects."
Avoid Disaster
Maybe the shift of emphasis from hard assets to cash flow makes sense to the lending banks, but for business owners it can be catastrophic when financing falls through at loan-renewal time.
Why should a bank call your loan? One reason is that many banks have weak balance sheets. This can create the need to restructure their own portfolios in ways that leave old customers thrashing for lifelines. In the current economic environment, banks are often merged and staffs reformed, and your long-time banking contact may disappear.
Often a bank that is in trouble will be under an order of the comptroller of the currency to reduce its commercial loans. In such a case, come renewal time, you may discover you need to pay off your loan in 30 days. That is not very long to get your building appraised and to find a new bank. And a new bank may well think something is tainted, even if your loss of a credit line is your current bank's fault.
Your credit line may disappear even before the maturity date of your debt, points out McQuaig. "A bank is bound to its agreements as long as you meet your covenants. For example, you may need to maintain a free cash flow ration of 1.5 to one. That means that if you have a $10,000 monthly loan payment, you need $15,000 monthly in free cash flow."
Get Ahead of the Curve
Given that a lending bank will likely analyze the historical cash flow of your business, it's smart to be proactive with your own analysis.
"Reach out to your banker right away if you think you are going to run afoul of one of your loan covenants," says Linda Keith, a CPA based in Olympia, Wash., with a niche practice in lender credit training. "Do this before the banker spots the problem. Make it clear that you pay attention and that you have a plan to resolve the issue."
And make sure your bank is aware of how well your business is doing. "If your company has done well during the recession, don't assume the banker knows it," Keith says. "The assumption may be that you are struggling when you are not. Send up the flag and the fireworks. Invite them to come see your business; give them a tour."
Small is Good
It's in your interest to assess the financial strength of your bank. For that matter, have a second bank in your pocket: You may need it when loan renewal time comes around.
That second bank may well be a smaller one. "As banks have become bigger in recent years, they have put fewer people on the ground and have become less helpful to business customers," says Marilyn J. Holt, a Seattle-based management consultant. "Many are no longer interested in handling little loans. It's a huge challenge for the small-business person."
Not only are smaller banks friendlier to small businesses, they may lend when larger banks will not. "Many community banks actually have too many commercial real estate loans and want to rebalance their portfolio by making business loans," says Keith. "They have money to lend if you can demonstrate your business operations will provide adequate cash flow."
And don't overlook another source: "Many credit unions are getting into 'member business lending,' as well," Keith says. "Many are in very good capital positions." And while credit unions are known for smaller loans, they can participate with each other to make larger ones.
On the Edge
Whatever your funding source, make a good impression by demonstrating a personal understanding of your business finances, Keith advises. "Are you one of the many business owners who are not real strong on the financial side of your business? Seek some continuing education in the topic. Look for workshops at your local community college or online courses."
And communicate with your banker. "Relationship banking goes both ways," Keith says. "A good banker maintains a relationship with you, but you also need to take the initiative. Get in touch early if something is about to happen that may be perceived as negative."
Being proactive will make you stand out, Keith adds. "Later, when it's time for the banker to go to bat for you with a loan committee, he or she can say that you maintain good business practices and called ahead of time when something was wrong. That can be the difference between 'no' and 'yes'."
