There are many moving parts in the process of obtaining a loan from inception, through application until the loan is closed. The focus of underwriting, credit analysis and risks management have become the cornerstone of the process. Banks and lenders are not only in a business of providing loans and other financial services, but also mitigating and managing risks with any associated assets, entity, sponsor or firm they plan to fund. This is why many ratios are used when performing credit analysis to determine if a borrower and the company can be funded and how much loan proceed will be disbursed. This short post is to quickly explain 3 of the 7 crucial steps banks and lenders use for sound credit analysis to fund business deals.
Step 1: Story About the Business and Borrower:
Lenders will want to understand in intricate details why does the borrower need a loan. The company could be in its inception, hence start-up capital of $1,500,000 as opposed to the initial of $3,500,000 the borrower sought could be more manageable due to risks of operating cash flow, short-term default, etc. Typically, three to five years free-cash flow forecasting is sufficient to have a lender interested in the granular aspect the business (this will be discussed more in part 2); however preliminary underwriting, in depth-due diligence about the business, partners, will also be instrumental in determining whether the bank or lender will proceed to the next steps in the funding process.
How robust is the management team? The owners must have skin in the game and should be able to demonstrate their capabilities of growing a company successfully. Having a great idea about a “real estate app”, a “driving app” or “a neighborhood restaurant” with a great business plan depicting that in year 3 the company will be profitable by 20% and cash flow will be up by 25% from previous two operating years in business may not be sufficient to get the borrower funded. In order to procure a business loan, the company and all sponsors will be evaluated thoroughly. All the pieces of credit analysis, risks management, and how such risks will be mitigated are very important. The story about the business is truly like peeling every layer of an onion.
Step 2 Accounting Mistakes:
According to GAAP (generally accepted accounting principles). Are the books sound and in order? Are there any disparities in the numbers on the balance sheet, etc.? This is very important because the firm relies heavily on these financial reporting to make sound business decision. For small businesses, the impact is not as drastic as a publicly trading company because of many stakeholders who sit on the board of directors. Crucial accounting mistakes will undermine the company’s credibility for a small business and for a much larger firm it can be doomed – think of Enron.
Step 3: Profitability Evaluation
The main objective of a company aside acquiring customers, clients, is to earn profit, as such, profitability measures the efficiency of the business. The main ratios bankers will look at for profitability evaluation are: gross profit, operating ratio, operating profit ratio, expense ratio, and net profit ratio. Let say Mrs. Violet owns a small business named GoNailsFlavor. In the last quarter of 2017 she lost 10 recurring customers. Since she is responsible for maintenance, insurance, taxes, she found out that in December 2017 she will need to spend $3,200 in addition to her $11,000 expenses.
Additionally, the landlord of the building decided to bump annual rent by 3% once the lease is renewed in January 2018. Suddenly, the business expenses get out of control (note: income is less than $8,000 during the last quarter and entering 1Q18) for the first six months in 2018. Because of this lack of control over the expenses, the profitability will be low. What does this mean? Lenders will be extremely skeptical about used of borrowed funds and loan issuance because the profit margin for the business will be shaky and there will be risks of loan repayment.
These three steps are the tip of the iceberg. In part two of this quick series I’ll expand on the next four critical steps lenders use for sound credit analysis to determine to fund the borrower.
By Ibsen Alexandre
The opinions expressed herein are those of the author(s) and do not reflect the view of a particular firm, its clients, any respective affiliates nor any Media Platform. This article is for educational general purposes only and is not intended to be and should not be taken as solicitation to lend.