Part Two on Commercial Lending with John Wroton, Assistant Vice President of Harrington Bank, Chapel Hills, North Carolina
Last time our focus was on the impact of risk and the “personal” aspects of getting the loan. Now we shift our focus to the “business” factors – from the loan application to collateral to funding options.
Typically what mistakes do first time applicants for loans make?
The biggest mistake that first time applicants make is thinking a bank loan will be the primary source of funds to start or fund a business. Banks want the owner to put in personal equity so t the owner has a vested interest in making sure the business is successful.
Otherwise there are no real mistakes,” just misconceptions about how and why a bank will lend money. A lot of times people don’t realize the bank will want solid collateral (i.e. cash, real estate, equipment) for a loan. Loans for leasehold improvements don’t offer good collateral because the bank can’t do anything with those leasehold improvements should the loan go bad. Sometimes people wait too late to come to a bank. When they are starting a business and have cash or other collateral to put into it, they will often think that they don’t need a bank loan. Then, when they have used up all their cash and go to the bank for a loan, it is difficult to get a loan. If they had come at the beginning, they probably could have gotten a loan because they had better financial strength at that time. A last example is the fact that the bank will want a personal guarantee. Some business owners think their business is strong enough to stand on its own. However, from the bank’s perspective, if you aren’t willing to provide a personal guarantee, it means you aren’t willing to stand behind your business. That raises a red flag to the loan officer.
Does the size of the business make a difference in the type of loan or the process?
Business size doesn’t play a large role in the type of loan or the process. The amount of the loan, the profitability of the business, and the collateral for the loan are more the determining factors. Of course, there is a difference between a small retail business owned and operated by one individual and a large public company. This difference will probably determine which bank is the best fit and the level of the loan officer who will look at the loan, but the underlying analysis of the loan request will basically be the same.
Do you make loans to all types and stages of business?
Yes. Community banks and smaller banks will tend to specialize in working with new businesses, as well as with smaller and medium sized businesses. Larger banks will have more products and services geared toward larger corporate and multinational companies. No matter the type or size of your business, there is a bank for you.
Cash flow from the business is important to the ability to make the payments. Are loans ever established with a “holiday” between getting the loan and making the first payment?
I won’t say never, but a payment holiday on a commercial loan would be very unusual. Typically, banks may allow for a period of interest-only loan payments in order to minimize the amount a customer has to pay. Also, the initial payment date for a loan is typically set at one month from the date the loan is closed, so there is a 30-day grace period until that first payment is due.
Can inventory be used as collateral?
Yes. Banks will consider all assets of the business when looking at collateral to support a loan request. However, banks usually discount the value of the assets by anywhere from 10% to 90% depending on the type of assets. Inventory is usually discounted by at least 50% because if the bank had dispose of that inventory, it would be unlikely the bank could get 100% of its value.
What is “factoring” and how does it work? Do you make loans against accounts receivable?
Factoring is a specialized form of lending engaged in by certain banks and other lending institutions. Under this arrangement, the borrower agrees that his customers will pay the “Factor” (the bank or lending institution) directly. In turn, the Factor will lend the borrower some percent (typically 75%) of the current outstanding receivables. This arrangement benefits the borrower, because they get cash in hand immediately rather than waiting for their customers to pay them. Also, the Factor typically doesn’t consider or need any other assets as long as it feels there is a good likelihood the receivables can be collected. The downside is that Factors typically charge high interest rates and fees, so the borrower does not end up receiving 100% of the receivable.
How does a business get a line of credit?
The process is basically the same for getting any other type of loan. The bank will want to see two to three years of financial history for a business (if available) and current year-to-date financials. The bank will most likely also want to see an Accounts Receivable Aging Report so that it knows how many customers a business has and how much of the receivables each of the customers represents. Financial information on all owners or members of the business is also important. The bank will look at all of this information to determine if a line of credit makes sense and the amount of that line.
How does a line of credit differ from a business loan?
A line of credit is typically used for short term cash needs while a term loan is typically used for longer term needs such as the purchase of assets with a useful life of 5 years or longer.
A line of credit usually has a one-year term. The borrower pays interest only on the outstanding principal balance. The borrower may also borrow and repay the principal balance repeatedly during the term of the line. At maturity, any outstanding balance is due, but, if the relationship is going well, the bank will usually decide to renew the line for an additional year. The bank will make sure the line is for short-term cash needs and may include a provision that the line must have a zero balance for a certain number of days during the term of the line. If a borrower continually carries an outstanding balance on a line of credit, the bank may decide to term out the balance over three to five years, forcing the customer to begin paying it back. Advances on a line of credit are typically done against a percentage of a borrower’s accounts receivable and/or inventory. For example, a business which needs to stock up on inventory in preparation for its busy season could use a line to purchase that inventory. The business would not need to use its cash (and may, in fact, not have enough cash) to purchase the entire inventory it needs. As the inventory is sold, the cash generated would be used to pay back the line of credit. This financing of inventory is the perfect short-term use of a line of credit.
There are set asides and special programs for many government programs for women-owned, minority-owned, and veteran-owned businesses. Are there any programs which provide special programs to these groups when starting a business? If so, how do they work and where do businesses find more information about them?
There are various programs available. Talking with a loan officer at a bank is the best way to get started, as he/she can usually help identify a program or refer you to someone with more information. The Internet can also be a helpful tool. Going to a search engine and putting in terms such as “minority-owned business loans” can turn up a wealth of information.
Are the terms of a loan something a borrower just has to accept as offered or can they negotiate?
There is usually some negotiating room in the loan terms. The interest rate, the amount of the origination fee (the fee the bank is charging for providing the loan), and the length of the loan are the typical places banks will negotiate. How the bank feels about the overall loan request will determine how willing the bank is to negotiate.
The loan process takes preparation. Starting the process early is important to having the ability to find the best relationship and terms. The less experience you have with assembling your financial results and projections, the more important it will be to get sound advice on the financial matters of your business.
Overly optimistic forecasts (projections of future results) damage your credibility with lenders. If you do not have at least three years of business results, then your ability to build a realistic, believable projection of your business future will make the difference between getting a loan and being turned down.
When generating forecasts keep these points in mind:
- Be methodical
- Be sure to have a balance sheet, profit and loss (income) statement, and cash flow statement
- Make the financial statements consistent and connected – the cash flow statement is a product of the balance sheet and profit and loss statement; it demonstrates how funds are generated and used – where and when you will be able to make payments on the loans
- Don’t omit expenses – they may lead you to an inability to make payments on the loans
- Base your sales numbers on “evidence” purchase orders, contracts, market share, and existing customers
- Relate the cost of products or services sold to your sales level – either as a percentage or on a per-unit basis
- Spell out your operating costs for facilities, salaries and wages, and marketing/sales
- Build the balance sheet to reflect the liquidity of assets – cash, short-term investments, types of inventory, and fixed assets
- Understand that working capital loans – money to pay the bills while waiting for payments from customers on sales made – are there to offset timing differences in sales and collections
Getting a commercial loan is a means to grow your business. It requires a realistic picture of your current and future business as well as a commitment to manage the funds in a manner which generates cash to repay the loan. Because personal guarantees are part of the package, you will need to develop your financial information for the loan application methodically.
Harrington Bank is a locally owned and operated community bank with two locations in Chapel Hill to serve all of your personal and business banking needs. Contact: John Wroton, Assistant Vice President, www.bankatharrington.com, (919) 945-7818, [email protected]
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