My banking career started out learning how to collect loans. The conventional wisdom back then was in order to learn how to make good loans you need to experience how to collect bad ones. So, my job was the “repo man” for a large commercial bank in North Carolina for the auto dealer department. Any car loan that was past due, I had the responsibility of either bringing the payments current or repossessing the car. Oh the stories I could tell.
From there I learned how to make personal loans usually car loans or home equity lines of credit. Early in my career, I learned the 5 C’s of credit:
I was only allowed to loan a certain amount (a lending limit). Above that, I had to get approval from my supervisor. This is how the bank handled risk. The more experienced you were, the higher your lending limit.
- Character-Will this person pay me back?
- Cash flow-Can this person pay me back?
- Collateral-If I have to take the collateral back, can I liquidate it and pay back the loan?
- Credit-Does this person have a good payment history?
- Conditions-Is the economy or this person’s industry favorable?
You see, it’s all about risk for a bank and a banker.
I did a really good job lending money to individuals so the bank promoted me to the commercial banking department. Loaning money to individuals is easy, but loaning to businesses is much harder. An individual has cash flow as long as they’re employed. However, I did learn about the 3 D's (death, disability and divorce) which also affect cash flow. These things also made lending to individuals a little harder. Also, if they’re unemployed, then you’ve got a problem.
But, businesses have more moving parts. So, the perceived risk is greater. The 5 C’s are still used, but the lender has to go deeper.
- Character- Will this person pay me back and does the company have a solid balance of sales, operations and financial management? A weakness in any one of the three can create a problem in the business. Most bankers know for a fact, the Achilles heel for most business owners is financial management.
- Cash flow-Will this person pay me back and does the business generate the amount of cash flow to pay the loan back consistently over time? The bank will look at three years of financial information and analyze the trends in your business to determine if those trends jeopardize the ability to repay. Banks can only afford to lose 1% of their loans, so they have to be right 99%, 100% of the time. It’s really hard to be that accurate. That’s why bankers appear to be so tough.
- Collateral-If the bank has to take assets back from a company, the liquidation value is usually so much lower than the value for a going concern. Most banks will do 75-80% of account receivable and equipment, but a much lower value for inventory usually about 40-50%. The margin hopefully gives the bank sufficient collateral to liquidate. However, the bank requires a personal guaranty of the business owner in case there’s a shortfall.
- Credit-Does the person have a good payment history and does the business have an established payment record that can be verified? Credit references seem to be a thing of the past. So, the banker uses the personal credit score of the individual to determine if the company is creditworthy.
- Conditions-Is the overall economy favorable and is the particular industry this company is in trending up or down? Residential real estate four years ago was in trouble. Now, it seems to be booming again.
In today’s market, the banker you’re dealing with probably has no lending authority. That authority rests with a person you may never see. Try to get to know that person with your banker’s help.
The mind of a banker thinks in terms of risk and reward. They have to be right 99% 100% of the time, so you have to help them by reducing the perceived risk of your loan. If you know you’re weak in one or two of the 5 C’s, then you have to make a compelling presentation to mitigate those with strengths in the others.
I've had two clients this week ask me this question. "Why are my sales up and my gross profit down?" One is in the manufacturing distribution space with four distinct product lines. The other is a rental product business with three separate products that feed each other.
The answer to this question is easy if you have one product line. Either you're discounting your price or you've had an increase in costs that you haven't passed on. If you have multiple products it becomes more complicated. It can be either of the above or it can be a shift in your product mix.
To demonstrate the impact on the shift in product mix, let's pretend you have three product lines which each comprises 1/3 of your total revenue. Product 1 has a 40% margin, Product 2 has a 30% margin and Product 3 has a 20% margin. Your overall gross profit margin should be 30%.
If all of a sudden Product 3 becomes 100% of your mix, your gross profit margin drops 10% if the mix becomes 100% of product 1 the reverse happens.
The issue of shift in product mix adds a level of complexity to understanding changes in your gross profit margin beyond discounting or an increase in cost of goods sold.
The best thing to do is to analyze your revenue by product line and gross profit this year against same period last year to uncover what's going on. (ytd July 2014 vs July 2013.)
All of us want to have the most profitable companies we can and this is a good way to understand what's driving your changes in gross profit up or down.
I have two clients that are looking at growth strategies this year. One has the opportunity to make some strategic hires that will grow the business dramatically. The other is looking at consolidating some debt, lowering his payments and using that cash flow to fund his growth along with a loan for additional working capital.
Let's assume one of my clients will grow from $10 million to $12 million next year.
If my client had revenue of $10 million with an average working capital of $500,000, he has 18.25 days in working capital. $500,000 x 365 /$10 million in revenue.
If you plan to grow revenue 20% it's safe to assume that your working capital will also grow 20% or $100,000. (20% x 500,000). The assumption is there will be no dramatic change to your inventory turn or collection period on receivables and no change in your payable terms. If there are changes that will affect your working capital then this assumption may be inaccurate.
So, how much cash does the client need to grow 20%? $100,000 approximately.
Both of my clients are going through an exercise like this to figure how to finance their growth. One will probably use their line of credit to finance their growth. One will refinance their debt and reduce payments to come up with part of the needed working capital. You may have other ways to accomplish this.
At this point you might be thinking, "OK I know how much cash, but where does it come from?" Here's the options:
- cash from profits
- cash from liquidating assets
- you can borrow it
- you can contribute it from personal assets
- you can take on an investor
There are pros and cons to each of these options and it depends on whether any of these options are viable for you and your company.
How do you grow your company? Please share some of your best practices with us! If you'd like to talk about how to grow your company please contact us.
Happy Friday! Enjoy some banking humor. If only it was so easy to balance your books!
Have you ever had that brief experience where you started driving in the dark without your headlights on? It was dark and you couldn't see where you're going. Running your business without timely and accurate financial statements is just as risky as driving with your headlights off.
I was having lunch recently with a CPA that I share clients with. He and I were discussing the fact that some clients don't see the importance of providing financial statements that are timely and accurate. Here's why it's important:
1) Running an income statement and balance sheet on a quarterly basis doesn't give you the granularity you need. You need to know month to month what your cash requirements are going to be (receipts - disbursements) so you can order inventory or meet payroll. That's the reason for timeliness.
2) Accuracy is needed to tell you the real facts about your business. If financial reports are inaccurate, it could cause you to make incorrect decisions about moving the business forward. Financial reports are not intended to keep you in the dark.
3) Having timely, accurate reports allows you to make comparisons against your budget, same month last year or same period year to date against last year. Are there any trends (positive or negative) that are developing? Can you expand or are your financials giving you a warning that you may need to layoff people or contract the business?
4) Inaccurate reports lead to trouble. If accounts receivable or accounts payable are either overstated or understated, it could lead to a cash crunch or you could be missing opportunities to take purchasing discounts which would improve your profit margin.
Providing financial statements that are timely and accurate is a process. It takes time to build the process and it gets more difficult the larger the business gets. But, it's a process worth implementing for all the reasons I've mentioned.
How are you doing in this area? Are there ways I can help you improve?
You’ve got a loan request. How do you decide if you pursue traditional bank financing or an SBA (Small Business Administration) loan through your bank?
We’ve closed several SBA loans this year. One was a debt consolidation loan with working capital, one was a new location for an existing business and one was a commercial mortgage refinance.
Remember that the credit standards that a bank requires are no different in an SBA loan and a traditional bank loan. You still have to have the 5C’s covered. (character, cash flow, credit, collateral and conditions). The biggest difference to an SBA loan versus traditional bank financing is the term and in one case the equity requirement. I’ll talk more about that in a moment.
Here’s the pros and cons of SBA financing:
- An SBA loan has a fee of 2.75 to 3.5% of the SBA guaranteed amount charged by the bank to pay the SBA for their guarantee. For a $1 million SBA guaranteed portion (typically 75% of the loan amount), that can be $27,000-$35,000. SBA guarantees up to -90% of the loan amount under import/export programs.
- The SBA 7a program offers up to 10 year terms on any loan that includes working capital. In some cases, that can have a debt consolidation component, a business acquisition, or a line of credit.
- The SBA 7a program when financing real estate can go up to a 25 year amortization.
- In the case of the purchase of an owner occupied building, the SBA 504 program offers 90% financing. The owner is only required to put 10% down.
The longer terms of the SBA programs make the cash flow easier to qualify for because the payments are going to be lower than traditional bank financing. In the case of the 504 program, if you’re buying a building that costs $1 million, the normal equity requirement could be $200-250,000. With the SBA 504 program, it’s only $100,000.
Remember the credit requirements are going to be the same for the most part. The big differences are the longer terms. Pursue traditional bank financing when you can handle the higher payments and avoid paying the guaranty fee. When you don’t have enough of a down payment for that building purchase, consider the SBA 504 program.
How have you used SBA financing in your business? Please share your experience in the comments section below.
How do you know it's time to restructure your debt? When your cash flow has changed and your payments haven't, it may be time to restructure.
I'm working with several professional practices that are looking to restructure their debt. All the practices are in growth mode and/or need additional cash for that growth. Growth ALWAYS requires cash because the investment you make in the form of increased people and salaries or equipment purchases occurs before the cash from increased collections comes in. In this case, the investment doesn't pay for itself. You will have a decrease in profit which decreases your ability to pay back loans. During the time you're working "on" your business conduct a debt review.
1) Calculate your cash flow coverage ratio based on your last year's financial statement or tax return. Banks are comfortable lending in to a situation where cash flow is 125% or greater of loan payments. Be sure you understand how your bank calculates cash flow (before or after distributions). I had one client that tripped his covenant over distributions.
2) If you don't have 1.25 coverage, can you consolidate some debts and extend the amortization so that your payments are lower? For one client, we were able to refinance their debts, provide $165,000 in working capital and extend the amortization. They needed the working capital for additional marketing and were able to do this and keep their payments about the same.
3) Sometimes restructuring your debt can accomplish a rate reduction and lower your payments. At that point, you have the option of keeping the payment the same and decrease the amortization (pay it back faster) or lower the payment and give yourself room to take on additional debt.
If you're going to restructure your debt, have a goal in mind. The most common ones are:
- Lower rate to acheive a lower payment
- Lower rate to pay the loan off faster
- Consolidate existing loans and lower your payment to take on additional debt for working capital or equipment purchases
Have your restructured your debt lately? Share your experience in the comments section below.
How much time do you spend with your balance sheet? Do you look at changes in liquidity and leverage from year to year? Are you monitoring changes in your collection period on accounts receivable and inventory turns?
In giving a presentation to a group of business owners yesterday, I was surprised at how little time they spent with their balance sheet compared to how much a bank spends with it. Banks measure trends in profitability, activity, leverage and liquidity (I call this PALL). Three of the four items are balance sheet measurements. Only 1 is an income statement.
I have a client that I worked with recently in the fast food business. He has several locations and is considering expanding. His profitability has been negative for the past two years but improving. He’s doing a good job of turning his inventory. The problem for him was his liquidity was below normal. He showed a book overdraft on his 2013 tax return (a red flag for the bank) and was only 3% of assets in 2012. A normal percentage is about 12%. Further his leverage was within industry standards if you include intangible assets (goodwill for the store purchases). However, since a bank can’t lend against intangible assets, the bank typically subtracts intangibles in underwriting leaving a leverage ratio of 3.3 to 1. This is about double of what industry standard is.
Given the lack of profitability combined with a book overdraft and high leverage compared to the industry standard, I had the uncomfortable circumstance of telling this client that he’s not bankable for the expansion plans he has at this time.
To be bank ready means that you’re not only profitable, but you have spent time with your balance sheet checking any changes in liquidity, leverage and asset quality (stale receivables or inventory). Only one measurement pertains to the income statement (profitability). Three pertain to the balance sheet. So, spend a little more time there.
How do you manage your balance sheet? Please comment and share your best practices.
Have you ever had the experience where you were trying to hit a deadline? Everything seemed to be falling into place, when out of nowhere something significant came up that delayed the entire process. You missed your deadline and paid the price for it.
This is actually happening to one of my clients right now. He has a very successful business. We have a term sheet from the lender with a favorable rate and terms. The lender has all items required except for “interim financials statements."
I have another client who is having significant operating issues and is in the Special Assets Department of the bank. His commitment letter states that he is to provide financial statements monthly to the bank. He hasn’t been able to deliver on that requirement due to the reduction in staff and the complexity of his business. However, he is not helping his case with his banker by continued delays in reporting.
Whether you know it or not, your bank(er) is forming an opinion about your firm on how timely you are in providing financial statements to the bank and whether they are accurate and complete. Bankers are looking for a balance of sales, operations and financial management in determining how bankable your company is. Financial reporting falls under the financial management piece. It’s a subjective call when your banker starts feeling uncomfortable about your loan based on your financial statements. However, when you’re slow that’s a heads up to your banker that something is wrong.
Here’s a few things to help you be sure your financial reporting is on track:
- Make sure you understand the legal and ethical standards and requirements for accounting and financial reporting.
- Drafting a financial report yourself takes a lot of accounting know how. Know when you ask for help from your CPA.
- Your financial reports have to comply with all current rules and regulations. The legal exposure of businesses has expanded and the amount of changes in account and financial reporting standards has increased.
Don’t let your lack of financial statements hold you back. I would encourage you to engage your CPA or hire someone to staff this important aspect of your business.
All the business owner clients I talk to are looking for any small sign of economic improvement. Unfortunately, after the reports from the first quarter, economic forecasters will leave us hanging with more lackluster results.
Severe winter weather and a record inventory build drove down GDP for the first quarter 2014 to a negative 1% annualized rate. To add insult to injury, corporate profits in the business sector fared even more poorly as pre-tax profits fell 9.8%/33.9% annualized. Records of corporate profits go back to 1947, and this quarter was seventh worst on record of the 268 quarters reported.
Even after weather and inventory problems, corporations took another hit in the form of increased taxes. At the beginning of 2014, several tax breaks on business depreciation expired and as a result taxes as a percentage of profits increased 3.5%. As a result of this increased tax, after tax profits fell 13.7% for the quarter/44.6% annualized. This was fourth largest decrease since 1947 and among the 1.5% worst.
So, what do we do? The economics is pretty simple, but the devil is always in the details. Tax revenue that flows out of the private sector and in to the public sector decreases productivity which decreases employment. For the economy to thrive, we need less money flowing in tax payments to the government. Those funds should be invested in jobs, technology and capital equipment. If we want a healthy economy, we should figure out a way to tax businesses less and give them the funds they need to invest and increase economic output and productivity.