In case you missed it here's Part 1: What To Do When the Bank Says "No" and
Part 2: What Are Your Options When the Bank Says "No"
You've been turned down by your bank for a line of credit. You've evaluated your options. Now how do you decide which alternative is best?
I have a client that wasn't turned by their bank, they just weren't given all they asked for. The bank gave two lines of credit, one was for $75,000 and one was an SBA line secured by specific accounts receivable for one of their clients. They still had accounts receivable available to pledge to another lender.
Their choices could be an asset based lender, a factoring company or taking on a partner. They looked at it from this point of view:
- The capital needed to be available quickly. So, speed was important to them.
- While the cost for an asset based lender or factor was high, they decided to go with the factor because it was invoice specific.
- The company had struggled with cash flow the first half of the year. So, any valuation for equity would have come at a significant discount off the true value. Plus, taking on a partner can easily take up to 3-6 months to arrive at any deal and they really didn't want a third partner.
Management is hopeful they can consolidate their factoring arrangement in to a line of credit increase with their bank and reduce their overall cost of capital. This would alleviate the need for an additional lender in their collateral pool with less paperwork. Ultimately, in making a decision like this you have to weigh the costs against the benefits. Speed of access was also important here.
You've heard the expression that "time is money." Sometimes you have to pay up for access to capital until you can reach a better long term solution. Ideally, I think all borrowers would prefer to have access to capital with a quick turnaround time at the least expensive cost.
In case, you missed it here's Part 1: What To Do When the Bank Says "No"
You've just been turned down by your bank for a line of credit. What are your options?
I have a client who was unable to get a line of credit because his company was unprofitable last year and the bank wasn't comfortable with his cash flow. You should go back to the 5 C's of credit and determine why you were turned down.
- Cash flow
Depending on which C was the culprit will determine what your options are.
If character, credit or cash flow were the issue(s), asset based lending may be an option. Asset based lending is where the lender is looking at the quality of the collateral (typically accounts receivable and inventory) as the basis for their loan versus these other factors.
There are two options:
First, is a company that factors your accounts receivable. With factoring, the lender doesn't loan, they purchase your account(s) receivable at a discount and include service charges and fees that increase their yield.
The second is a lender that loans you money against your accounts receivable, typically at a margin between 75-85%. They also charge interest, services charges and fees that increase the cost of money. Usually, this type of lender will charge an interest rate (when you include the service charges and fees that could be anywhere from 18%-30%. This is expensive financing and should be considered carefully.
Let's say you have all the C's covered except cash flow. Many times SBA lending programs provide an option due to the terms provided. SBA allows working capital to be repaid over 10 years, same with business acquisitions. The longer term calls for a lower payment which may help improve your cash flow. You pay more interest expense because it's over a longer period of time, but this option may be attractive.
Maybe you're short on collateral in your business? To make a collateral shortfall work, you may pledge personal assets to secure your loan, real estate, cash value life insurance, listed securities (non-retirement accounts).
If these options don't work, then you may not be a candidate for a loan right now. You can either put in the equity yourself or take on a partner.
If you're a credit card merchant, the credit card company you deal with may be willing to give you a cash advance on the merchant credit card volume you generate. But be careful, because you are mortgaging your future for the present and this program is expensive just like asset based lending.
In any situation, consider the cost of capital in your financing decision. The more expensive the financing option, the more impact it has on your profitability. Don't let financing costs eat up all your profits.
What options have you pursued? Which ones have you found work best for you? Please share your successes.
When the bank says "no" to your line of credit that could be the initial signal to you that your business may have a problem borrowing money.
I have a client who is experiencing cash flow issues. She doesn't have a revenue problem, she has an expense problem. We are in the process of correcting it, but the company will show a loss for the year unless some really big revenues hit between now and year end. If you approach a bank while you're losing money, the bank will tell you that they want to see a full year of profitability before they issue a line of credit. Banks don't want to fund operating losses with their line of credit. They want you to take that risk.
If the bank says no, it's likely that one or several of the "5 C's of Credit" are the culprit:
- Cash Flow- The bank is looking for cash flow (net income + plus interest and depreciation expense) to cover loan payments with a 30% cushion. This means that $130,000 of cash flow is needed to cover $100,000 of loan payments. If you have losses or your cushion is significantly less than 30% the bank will not approve your request.
- Character- For whatever reason, the banker didn't feel confident in your ability to run the business. You could have said something that caused the bank to lose confidence in you. Banks want to loan to people of good character.
- Collateral- Banks want the loan to be 100% secured with margined collateral. The collateral can be business or personal assets. They will not loan dollar for dollar. They will assign a margin requirement in the event of liquidation. 75-80% of eligible accounts receivable for example. If you don't have enough collateral to support your loan request, they will not approve it.
- Credit- Your personal credit score is the bank's indicator for how you will repay your loan. They believe you will handle your business credit the same way you handle your personal credit.
- Conditions (primarily, industry or economic) If you're in an industry that is declining or if economic conditions (GDP and job growth, consumer spending) are trending negatively, the bank may choose not to loan to your company. This one is especially tough because it may have nothing to do with you and your company.
Sometimes the problem is not you and your company. The bank may be the issue. If a bank is having capital adequacy or liquidity issues, they may have turned down the lending faucet temporarily. Another reason could be they may have too much of the loan type you're asking for on their books already (investment real estate for example).
However, if the bank says no, it's time for some self awareness and reflection to determine the reason(s) why.
Ever heard of structuring? Some have, some haven't.
My first job as a bank management trainee, was to run a teller window for three months. You wouldn't believe the things you see as a teller. Possibly, the most curious question I got was, "How much can I deposit without having to file a currency transaction report?" which goes to the IRS.
Little did they know that they were asking me to help them "structure" a transaction. Structuring is executing financial transactions in such a way to avoid the creation of certain records or reports as required by law such as the Bank Secrecy Act or the IRS code.
Structuring is often included in indictments related to money laundering, fraud and other financial crimes. Under the Bank Secrecy Act, when a bank receives a deposit of more than $10,000, the bank is required to have the customer complete and sign a Currency Transaction Report (CTR).
Further, if the bank suspects that a person is structuring transactions for the purposes of avoiding the law, they must file a Suspicious Activity Report (SAR). If a bank employee is complicit in assisting to structure transactions they could be subject to a fine and up to 5 years in prison.
A New York Times article recently reported that many businesses make small cash deposits and are not structuring. Their intent is merely to deposit the daily cash receipts of their business with no intent to avoid the law. However, if they're suspected of structuring, the IRS can seize their funds and begin an investigation. A bank employee who is concerned about assisting in structuring would file a SAR on the business which could trigger an investigation.
If you didn't know about structuring before this article, now you know a little. Money laundering, fraud and financial crimes have been estimated in the billions of dollars annually and in 1996 were estimated at between 2 and 5 percent of the world economy according to the International Monetary Fund. Because banks ultimately could become the recipients of laundered money, the government has setup guidelines and procedures for reporting large cash deposits at banks thru the Bank Secrecy Act and the IRS code.
The best way to avoid having your bank file a Suspicious Activity Report (SAR) is to remove the suspicion. Introduce yourself to someone in management at your branch and tell them about your business. Explain to them that you have a cash business and make daily deposits of your receipts. Your intent is not to avoid any reporting requirements the bank may have, this is just ordinary course of operations for your business. You know the expression "an ounce of prevention is worth a pound of cure"? That's probably very applicable here.
Baby boomers preparing for retirement are driving the sale of small businesses like never before. As a business owner, no matter what size or stage your business is at, you must plan and implement a strategy to have your business ready for sale. Here are 5 tips for your to consider when selling your business. I have several clients that are at various stages in this process. For some, the time horizon is less than a year away and another is looking at 10 years from now.
- You've got to have a plan. Most people don't think about this until they are approaching retirement. By then, it may be too late. What amount of money in after tax dollars do you need to have financial independence and how many years do you have to get there? In addition, preparing includes having a succession plan for your departure. Preparing your business for sale won't happen overnight. It takes time.
- Having complete and accurate financial records is critical to give any buyer confidence in purchasing your company and negotiating a higher price for you. This starts with detailed annual budgets. In addition, company prepared financials for the past three years and tax returns will be requested during due diligence. Any inconsistencies in those records gives the buyer leverage to reduce the purchase price. You should establish a cutoff for monthly financial reporting and then prepare balance sheets and income statements monthly to track your progress against budget. Accurate historical budgets gives credence to your company's projected profit.
- Schedule regular board or internal review meetings. Buyers want to see records showing good governance (including minutes of meetings) and accurate financial information. This information reduces the risk taken on when purchasing the business.
- Buyers value businesses with long term leases for key locations, protecting intellectual property with patents/trademarks and having employment agreements for key employees. This also reduces the risk associated with purchasing the business.
- To the extent you can, enter in to long term contracts, such as supply and distributions agreements, with important customers and suppliers. Make sure those agreements are assignable to a potential purchaser.
There are many other areas to consider when selling your business. But, these are a critical portion of obtaining the maximum value for your business when you sell it.
The SBA hosts guest bloggers on the website from time to time. There was a recent article on their website discussing this issue:
"Due to the growing difficulty in obtaining traditional business lines of credit from banks, many business owners are turning to credit cards for small businesses as their primary unsecured business lines of credit."
I had a client recently who was in the process of obtaining a debt consolidation loan which would've paid off several business loans and credit cards. However, one of the credit card providers reported his business payment history to his personal credit bureau report. This dramatically reduced his credit score and may prevent him from successfully completing his refinance. Here's why:
Business owners are turning to credit cards as their primary source of unsecured working capital credit. The unintended consequences of that decision is that they end up putting their personal credit on the line and their business credit cards show up on their personal credit report.
Any time you use a business credit card your personal debt/credit ratios are affected. Many financial institutions offerring business credit cards report to your personal credit which can negatively impact your scores.
So, before you apply, ask the lender if they report your business credit card to your personal credit report. If so, continue the search for a business credit card that doesn't. If you're having a hard time locating a business credit card issuer that only reports to a business credit bureau, then call the bureau and ask them which credit card issuers report to them. If that's not practical, then conduct your own search, but that will probably take you longer.
Business credit cards have been around for a long time. They are great cash flow tools and usually carry interest rates competitive with other unsecured business credit sources. Just do your research before you apply. Some additional due diligence can save you potential negative impact on your personal credit report.
Happy Friday! Enjoy some banking humor to kick off your weekend!
Your banker might have mentioned that they underwrite your loan using global cash flow analysis. What is that and why do you care? Let me tell a story and hopefully illustrate it along the way.
I'm currently working with a personal services firm that has three affiliates. They have 4 partners and at least 4 different product lines. The firm wants to borrow $500,000 to payoff an existing line of credit and provide working capital to expand their practice in different areas of geography. In presenting their package to the bank it occurred to me, what if the affiliates are losing money and the firm has no cash flow to service debt? What's the impact if the partners pull all the money out of the firm and there's no cash flow left to service debt? I carefully looked at the income statement of all the affiliates. They are making good money and are not a drag on the firm. I looked at the personal tax returns of the partners and determined that they are drawing ample salaries to cover their personal lifestyles and don't need to distribute profits. I concluded a global cash flow analysis was not necessary in this circumstance.
Professional and personal service firms (doctors, dentists, attorneys, consultants) are potential candidates for global cash flow analysis. Global cash flow takes income from all personal and business sources, (salary, business profits, real estate, rental income etc.) and then takes the loan amount requested plus all other business debt and personal debt. Since the cash flow of the business and the business owner are entwined, a banker wants to be sure that his business loan can be repaid without issue. Additional items like interest expense from the business and non-cash charges (depreciation and amortization) are included. Most bankers will take all income taxes paid (federal and state) out of their cash flow because they're not available for debt service. Also, most lenders will make an allotment for living expenses too.
I hope I'm not getting too technical, but here is how you can calculate your global cash flow. Lenders will take the AGI (bottom of page 1 on your personal tax return) and add interest expense and depreciation from your business return, any other affiliate business tax returns you have and from your Schedule E. The total of all that is the global cash flow. You take the principal and interest payments of all business and personal loans. That is your debt service. You divide global cash flow by all payments to come up with your global debt coverage.
The same standard for debt coverage applies for global cash flow analysis. Banks are looking for a 1.2-1.3 cash flow coverage.
You might be thinking so why do I care? Well, my client I mentioned has a debt coverage of 2 to 1 much greater than the 1.2 required. However, let's pretend that after you factor in personal loan payments that debt coverage is reduced to 1 to 1. All of a sudden, this borrower doesn't have the capacity to take on additional debt because all of the cash flow is being used to cover personal loan payments. It's important to know what your borrowing capacity is and if your bank underwrites this way. You want to be sure you're asking for a loan that will be approved.
If you are one of the professional firms I mentioned above, it's likely that your bank will use a global cash flow analysis to approve your loan(s).
As we enter the fourth quarter, it's time to start planning for 2015. I have a client that is beginning the budgeting process for the first time. We're looking at their opportunities for new business. They have a lot! We're looking at how they've calculated their costs in coming up with sales and profitability assumptions that are realistic and attainable. On a regular basis, we will track our actual results vs. budget to see how accurate our assumptions were. It's likely mid year adjustments will be made. Here's my top 5 tips to maximize profitability as you plan for next year.
- What's my tax liability this year? It's time to figure out what your actual liability is going to be for the tax year 2014. Get with your CPA and get their help in calculating how much of a check you are going to have to write in April. Will you trigger AMT? There are rules as to how much you need to withold this year to avoid penalities. They can make suggestions on how to reduce your tax liability by making contributions to a retirement plan or health savings account or taking accelerated depreciation on fixed assets purchased in the current year. These are just a few.
- Think ahead. What's your strategy for this year? Will you grow? Are you changing your management model to increase sales or improve internal efficiency? What about marketing? Will you go after new markets or introduce new products? If you grow, will you need money to do so? It's time to dream a little bit and convert those dreams to plans.
- Take your plans and convert them to actions. What assumptions do you need to change? Revenue or profit growth? Will you add any one time or recurring expense as a result of your strategy? Those assumptions should include two factors (internal and external). What's your average growth rate (internal)last year? For the last three years? I had a client who was trying to grow 20%, but his historical growth rate was 1/3 of that. Make sure you're being reasonable. Also, compare your assumptions with industry forecasts and benchmarks provided for your industry by third parties (external). If you forecast 10% growth, but your industry forecast is 20%, you may be missing an opportunity.
- Budgeting is part art and part science. Compare your actual results against your budget monthly. If there are significant variations in categories, it's time to figure out why. That may help in your budgeting process next year.
- Do your budget for 2015. I would suggest starting at the bottom and work up. How much profit do you want to make? Add your expenses on top of that to derive your revenue number. Is the revenue number reasonable given the internal and external factors in #3? Many people start at the top and work down. They may end up with a profit number that's not acceptable. So, start with profit first.
I know this is a lot of questions to ask yourself, but they are important for a business owner to consider. If you'd like help planning for your company's success please contact us
. What top planning points do you use as you begin the budgeting process for 2015?
Consolidation loans, do they help or are you just paying more interest for the money you've already borrowed? When do you consolidate your loans and when do you do nothing and let them run their term?
I worked with a professional practice earlier this year. The practice obtained an SBA loan with another lender several years ago and had taken out equipment loans and other lines of credit to finance the practice. The practice had a 60% gross profit last year, but even with a nice cash flow they were struggling to grow the practice. A majority of their cash flow was going to debt service and supporting the doctor's personal expenses. In addition, they had used the original SBA loan to do some marketing which really helped the practice and they wanted to obtain some working capital for marketing again.
Because of the high gross profit, it made sense to consolidate these loans and obtain some marketing money for working capital. The cost of this capital is currently about 6%. Investing that capital to grow the practice would still net a 54% gross profit after borrowing if their margin holds. Plus, the lower payments would provide other dollars to cash flow the practice and pay the doctor. While they are paying more in interest expense, the key is to use the cash flow previously paid to lenders to generate additional sales with a high gross profit margin. If they can't achieve that, then they shouldn't consolidate the loans.
If your firm is in a growth mode and you can use the cash flow created from the consolidation loan to generate sales and you have a high gross profit margin, then it should make sense to consolidate. If your growth rate is moderate or your cost of capital is high, then it may not make sense to consolidate your loans.
Have you consolidated your loans to free up cash flow lately? How did it work for you?