Over the past 90 days, we've seen credit start to tighten. Credit underwriting has become stricter, interest rates and fees have started to increase and it's just harder to borrow money than earlier in 2014 and the year before.
The Quantitative Easing Program initiated by the Fed was officially terminated in October 2014. In a recent survey, about 50% of the banks believe either this will cause mortgage interest rates to rise, which will in turn curb housing growth this year, or the increase in interest rates will cause financial distress in those institutions that did refinances in a lower interest rate environment.
About 78% of lenders believe that unstable energy prices and the housing market have the potential to create the greatest negative impact on the economy in 2015. The drop in oil prices will force energy companies to cut back on production until supply decreases or demand increases. Also, an increase in interest rates will have a negative impact on home purchasing which could cause home prices to drop or newly constructed homes to sit in inventory much longer than expected.
For the first time in the past 5 years, more lenders expect to tighten their loan structures than relax them. This seems to indicate a more cautious credit outlook than we have seen in recent years. Further, more lenders indicate that they plan to increase interest rates and fees than maintain or decrease them in 2015. The combination of tighter loan structures combined with interest rate and fee increases indicate a less attractive borrowing market for 2015. Lenders appear to be moderating their aggressive structure and pricing over the past couple of years. The question remains if they can successfully do this on their strongest credits or just limit it to marginal ones.
In an industry outlook by one of the major consulting firms in the country, banks have been positioning themselves for growth and profitability. An increase in GDP should drive greater loan originations, which will boost profitability. However, new liquidity and leverage standards for banks enforced by regulatory agencies could force banks to hold on to low yielding assets and place additional capital burdens for some assets. Even with the increased demand and more favorable interest rates, some banks may not be able to take advantage of the market due to these new regulatory requirements. It's interesting to note that loans made up 56% of the total assets mix of banking across the country. During the Great Recession with declining interest rates and more regulatory requirements, loans now total only 51% of total assets 7 years later. These circumstances will continue to create consolidation in the banking industry where banks that are marginally profitable and only moderately capitalized will merge with larger banks due to economies of scale.
C&I Lending (commercial and industrial) will be a primary driver of growth for many commercial banks. Wealth management remains an attractive line of business due to the fee income potential. Mortgage lending will be depressed due to an expected increase in interest rates and the lull created by the refinance boom when interest rates were low.
So, with the demise of Quantative Easing, banks expect a more favorable interest rate envirnoment and will expect to increase interest rates and fees. However, banks are still concerned about unstable energy prices and the potential of another housing bubble that could burst. More banks are reporting that they intend to tighten credit structures than relax them going forward. This is the reversal of a five year trend. In a favorable rate and economic environment, regulators are increasing leverage and liquidity requirements for banks, which could impact the supply of loans available in the market. It can also increase M&A activity in the banking industry for leveraged, illiquid banks to be acquired.
So, what does this mean for your business?
Unfortunately, any improvement in the rate and economic environment could be offset by increased regulatory requirements. It appears that the business owner needing to borrow money to finance his/her business, could expect a potentially tighter credit structure with higher interest rates and fees based on data from lender surveys and leading consultants in the banking industry.
Credit structure is very difficult to negotiate with a bank. The loan amount, covenants and term are all part of the credit structure. Do the best job you can to negotiate the largest loan amount you need for the most favorable term (1 year for a line of credit) with the least number of covenants, but realize when the bank delivers your commitment letter, the credit structure is pretty much cast in concrete. However, interest rate and fees are negotiable. Non-interest bearing deposits are a great negotiating tool for you. What's the best way for a bank to increase liquidity? Give them deposits. Because 90% of a bank's loan funding source is deposits, you can trade deposits for a lower interest rate and fees. Let's pretend the bank is loaning you money at 6% and they pay you 0% on your checking account of $100,000, that's a 6% spread or $6,000 a year benefit to the bank. If the bank is willing to give you credit for 1% of that 6% spread, that's a $1,000 benefit you can use to offset your interest rate or fees.
Have questions or concerns about your banking relationship or line of credit? Leave us a comment or contact us here.
You might be dissatisfied with your performance last year and want to increase revenues and profits or you want to continue to grow in the upcoming year. What are your options? Here are 5 ways to consider:
- Increase leads. You have a solid customer base, but you would like to add more customers. The best way is to increase the number of leads your sales people are calling on. Nobody likes to cold call, but have your sales people really done a good job of asking their customers for referrals? People do business with people they know. So, ask your existing customers for introductions to help add to your customer base.
- Improve your close rate. If you see 10 leads and make 3 proposals and get 1 client out of those, you're batting average on proposals is .333. What if you could increase the number of proposals to 5 and get 2 clients? You've just increased your batting average to .400. Most of the time, you can improve your close rate by asking good questions, listening well and seeing the benefit of doing business together from your customer's point of view. Always be sure you're dealing with the decision maker and you understand the customer's decision making process.
- Expand your relationship with each customer. If you have other products that your customer may use, be sure he/she knows about them. Also, your customer may be using one of your competitors and you don't have all their business. If you don't ask for that business, you definitely won't get it. So, ask for additional business from your customers. If you have 5 customers doing $100,000 each and you increase each customers volume to $200,000, you've just doubled your revenue from that customer base.
- Increase your average $ sale. If you feel your business is close to capacity, it may be time to look at the bottom 20% of your customer base. Remember the 80-20 rule. 80% of your business comes from 20% of your customers typically. That means that 80% of your customers only comprise 20% of your revenues. To create capacity, look at which customers generate only small orders and look for ways to replace them with customers that make high dollar orders. This takes some courage, but the benefits outweigh the risk.
- Increase margin. When's the last time you had a price increase? Also, are your vendors increasing prices and you're absorbing those increases without passing them on to your customers for fear of losing their business? If you're not losing a few orders because of price, then it's likely your prices are low and you need to consider an increase.
How do you boost revenues and profits? For additional articles on related topics, these posts may be helpful. I wish you a prosperous New Year!
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.
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).
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?
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.