After almost 4 years, it’s done. Finished. A business owner and a bank have settled their debt. Both parties probably feel a huge burden has been lifted.
The bank helped this client build a multi-tenant retail property. It was built at the top of the market. My client owned the largest part of the property and started a business in it. When the Great Recession hit, my client couldn’t get to break even, pumped more money in to the project and business. Tenants had a hard time making rent payments because they had their own issues. Tenants vacated or went out of business. New tenants that came in negotiated lower rent rates which decreased the amount of cash flow to make the loan payments. It was a perfect storm of circumstances and the property began to decline in value. Pretty soon the owner was upside down.
The lender declared a default and went in to a forbearance agreement. There was a cash flow covenant that had been broken. For the next two years, we intended to refinance the property and hoped the cash flow from the business and the rental income from the tenants was sufficient to cover the debt. However, when year end tax returns came back from the CPA, the business still wasn’t at break even. The cash flow from the business and the rent payments weren’t sufficient to refinance the loan. The owner was hopeful that the future was going to be better than the past, but the numbers never proved that out.
To renew the loan, the lender asked for more collateral than what was previously pledged. They also increased the rate and the fees in exchange for more time, but the lender was quickly losing patience in giving more time. Finally, the last renewal was based on all the properties securing the loan be listed for sale in hopes of liquidating a substantial portion of the loan. At that time, the bank was holding a loan balance of $2.3 million with properties listed for sale at about $1.3 million, a $1 million deficiency. We were successful in selling one of the five properties for $300,000 which decreased the loan balance, but made no progress toward the deficiency.
The properties were not selling, there was no dramatic improvement in the cash flow of the property and the owner’s business. Finally a settlement was reached. The lender agreed to take back the properties they held as collateral, settle the debt for a portion of the balance outstanding in exchange for cooperation of the borrower during foreclosure proceedings and the turnover of the property to the bank. My client was allowed to stay in their business for at least another two years in hopes of getting it turned around.
The owner has been released of the cash flow burden of an underperforming property and the settlement of a huge debt which could have had a devastating effect on their estate. With that behind them, hopefully they can focus on the business and improve it’s profitability and maybe get some of their investment back over time.
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.
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.
If something is too good to be true it usually is. Right? So, if you think you’re going to get a fixed rate from a bank and not pay anything for it, that would be too good to be true. Beware of the prepayment penalty.
I have a medical professional that is looking at options for buying a building. The lender is a big bank that is proposing two SBA options, the 7A and 504 programs. Big banks are willing to provide long term fixed rates because they have a lower cost of funds. Sometimes a bank can provide interest rate swaps through their capital markets department. An interest rate swap is where the bank and borrower swap cash flows (bank wants a floating rate and the borrower wants a fixed rate) and they use a third party to accomplish it. Even interest rate swaps have prepayment penalties. It's just referred to as a make whole provision.
The bank is offering a fixed rate of 5% for 20 years with the 504 and 4.75% for the same period thru the 7A program. Both are very attractive.
You have to know where to look in the commitment letter, but both options had a prepayment penalty of 2% in the first two years in option 1 and a three year prepayment penalty of 5% in year 1, 3% in year 2 and 1% in year 3 in option 2. The range of prepayment cost in both options is a low of $26,000 and a high of $120,000.
While it’s unlikely that interest rates would fall further, we have seen circumstances recently where interest rates moved against the commonly held view which triggered a significant number of refinances and in this case triggers the prepayment penalty.
If the fixed rate offer you have is attractive, go the extra mile to see if there’s a prepayment penalty in the fine print of the commitment letter. If you don’t see one, then ask your lender to be sure you don’t give them a good faith deposit only to be surprised when you sign loan documents.
What do a business owner buying a second business, a professional practice wanting to get a line of credit and someone buying a large piece of special purpose real estate have in common? They all want to know if their particular deal is bankable.
'Are you bankable?' is a common question for severals reasons:
- Most business owners don't know if they can borrow.
- They don't know how much they can borrow.
- They don't know at what rate and terms they can borrow.
There are five things you need to be bankable:
- Banks are information junkies. They need three years of financial information to evaluate your company. Your ability to produce complete and accurate financials in a timely manner is critical to your success. I have had clients that gave me a balance sheet that didn't balance!
- Spend some time with your balance sheet. Banks look at how much skin you have in the game (your net worth) versus how much your lenders have. If you're greater than $3 of debt to $1 of net worth you're approaching the unbankable line.
- Cash and cash flow are king. It's how much you keep that pays back loans, not how much goes out in taxes or distributions. Bankers are looking to cover any loan payments with cash flow and have a 25-30% cushion.
- What's your credit rating? Most banks use the owner's personal credit score as the proxy for a business credit rating. They feel if you pay your bills on time, the company will too. Banks also view your ability to pay on time as a testimony to your character.
- Collateral is required in every situation and the loan should be covered 100% by margined collateral. Most banks will loan 75-80% of AR, equipment and real estate. Other types of collateral carry higher or lower margins depending on the type.
If you have these items nailed then you shouldn't have a problem finding financing
unless something is wrong with the bank. Whatever situations you are struggling with in these areas will affect your answer to the bankable question.
to discuss the details of your deal and find out if you're bankable.
Are you bankable? If so, what amount can you afford to borrow? And at what rate, terms and collateral? Also, which bank(s) do this type of loan? Business owners don't understand the variables or the metrics. It takes a guide.
Within the last two weeks, I've talked to a doctor wanting to do a debt consolidation loan for his practice, a pastor about how much his church can borrow to build a building, and a restauranteur that is being offered the real estate that his restaurant sits on. All these questions come up and business owners really don't understand their options.
So, what are the 5 tips that make your deal bankable or not? Here we go:
1. Do you have skin in the game? The days of banks doing 100% financing (if they ever did) are gone. For real estate 20-25% equity is a rule of thumb, there are exceptions. The same is true with equipment and the same with buying a business.
2. Do you have the cash flow to repay the loan with ample cushion? Banks are looking for your historical cash flow to repay the loan with a 20-30% cushion. Cash flow can be defined from the business only or from the business and the owner combined.
3. Does the collateral you're providing (when margined) cover the full loan amount? Banks are willing to loan 75-80% of real estate, equipment and accounts receivable; less on inventory, but more on cash value life insurance or some listed securities.
4. Does your company have a well proportioned balance sheet and a history of profits? What does well proportioned mean? A fair amount of liquidity (5-7 days sales in cash for example) and less than $4 of debt for every $1 of equity. The last year should be profitable, preferably the last three, in order to obtain financing.
5. What are the prevailing economic conditions in your industry? During the Great Recession, residential and commercial contractors really struggled, many went out of business. Now, these industries are really doing quite well. Is your industry cyclical? Where are we in the cycle and is it expanding or contracting?
Once you've answered these questions, you're halfway home. The next step is to find a bank(s) that is doing the type of lending that you're looking for. Stay tuned for part 2, finding the right bank for your loan.