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Here’s some good news for anyone in the wood flooring industry seeking a loan: Banks are showing new signs of vigor after a long period of infirmity following the financial meltdown of 2008. 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, citing expansions and acquisitions. Also, the time has never been better for restructuring loans with more favorable terms. “Interest rates have continued to settle downward to a degree we did not expect,” McQuaig says. “There is still a good window to get long-term debt financed at lower rates.”
Leaping Hurdles
Although the general climate for loans has turned sunnier, getting to “yes” is no cakewalk. Part of the problem is that the economy, while showing improvement, is doing so slowly. Banks are 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. Marry that with a persistent low interest rate environment, and many loan officers sit on their hands.
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 Bill McDermott, CEO of Atlanta-based McDermott Financial Solutions. “Those are character, collateral, cash flow, credit and [economic] conditions.”
In the years prior to the Great Recession, many banks were willing to make loans with one or two of the Cs missing. Not so today. Cash flow, in particular, has taken a front seat to reduce the risk of default.
“Cash flow pays loans back,” McDermott says. “Very often banks will require that a business maintain cash flow of 120 percent; some banks go to 130 percent.” It’s not unusual today for a bank to ask for cash flow reports for the previous 18 months.
Cash flow requirements may become even more conservative because of widespread expectations of rising interest rates. “The bottom line is you have to have as much cash flow as you can,” McQuaig says.
Read Your Covenants
Cash flow (and other) requirements are defined in the “covenants” that appear in your loan document. Ignoring them can be costly. “Covenant compliance is very important to banks,” McDermott says. “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.”
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,” McDermott says. “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 sale of inventory and real estate to skinny down your company to its core profitable business.”
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. “That’s where they get into trouble.”
Seasonal or cyclical businesses (such as retailers) have a special problem, Holt says: 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.
Big Bank or Small Bank?
It may be time to reassess the banks you approach. Even in the best of times, larger banks with household names may be less than ideal partners for the small enterprise, because many tend to be interested only in clients requiring more than $50 million in financing.
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,” McDermott says. The reason: “There was a point in time 20 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 salespeople.”
As a result, smaller banks are often more attractive to small businesses. “Community and local banks are doing well financially, have no or fewer regulatory issues and are also more open to making small-business loans,” Holt says.
The right community bank will take the time and effort to understand your business requirements, but do your groundwork first. “Start by figuring out your business vision and be able to articulate it,” McQuaig says. “Then make sure your bank understands it. Build a relationship with one or two bankers who 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, because they are relatively new to commercial lending. One particular pitfall, says McQuaig: “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. “When I go into my local community bank, everyone knows me,” 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.” The result is that everyone in the bank calls Holt by her first name, and that personal touch can help resolve business issues.
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 online from the banks themselves,” Holt says. “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,” McDermott says.
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.
As for getting references, a prospective bank will not give you names of current business customers because it 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,” Holt says. “If not, the individuals might have been hired as salespeople 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.
Although the loan climate is better than before, carefully consider your plan to woo your bank. Make sure the five Cs of credit are strong, covenants read and that your chosen bank passes the capital litmus test.
