What Bankers Look For And Why

I am sure that you have heard many things regarding securing commercial credit. For example, most business owners seeking funding for their business have heard of the 5 C's of credit:

Character,
Credit,
Cash Flow,
Capacity, and
Collateral.

The problem is 'what do these really mean as they relate to you and your business in securing funding?'

As a former commercial lender, there was never a time that I thought about the 5 C's of credit in of themselves. What I, and my colleagues, wanted to make clear in underwriting credit facilities was two primary perceptions.

First, does the intended borrower have the ability to repay the debt? Debt in this case also includes all outstanding debt the borrower may have during the term of the requested facility (loan). This relates to both cash flow and capacity listed above but not entirely in the manner that most purveyors of the 5 C's would want you to understand.

The question is this, can you, as a borrower, repay the loan? Does your business generate enough cash flow to cover your operations (both variable and fixed costs) and still meet the minimum monthly payment of this new loan and all outstanding debt?

Cash flow is critical because without free cash flow (income after all other obligations are satisfied plus depreciation) a business owner would not be able to repay the principle and interest of the loan - the only thing that a bank or lender really wants - for you as a borrower to repay the principal and interest.

The focus here is on past performance - not what the business owner thinks the business will generate in the future. Bankers do look forward but usually look at past growth rates and apply them forward. Example, if your business has grown, on average, 3% over the last three or more years - then that 3% will be applied in calculating future growth.

Further, bankers want to know if the business can withstand a downturn in the market or economy and still generate enough free cash flow to service the intended facility (loan). Here, the bank runs a 'worst case' analysis against past performance - e.g. multiplying all past revenue figures by 85% or 90% while keeping all costs and overheads the same. If the business's income still passes the test, the business will meet the repayment ability criteria.

Additionally, bankers want to see a greater than one-to-one ratio with cash flow. Example, the principal and interest of the requested loan relates to a $1,000 per month payment. If the business generates $1,000 per month in free cash flow, the business should be able to make the minimum monthly payment. However, what happens when the business faces a slow down and only generates $800 a month in free cash flow? This slow down can stem from problems in the business, the market, the economy or from world influences just like the financial crisis the world faced in 2008. Bankers want to see a greater than one-to-one ratio; meaning that the free cash flow of the business, in this case, should generate $1,250 or greater in cash flow - which is 1.25 times the minimum required to service the requested loan. Thus, if there is a slow down, the business can still meet the minimum payment.

However, not having the free cash flow to service the debt from within the business does not in itself kill the deal. A borrower with enough personal income or a guarantor with personal capacity to service the debt would suffice for the perception of "ability to repay."

Second, does the intended borrower have the willingness to repay the debt? This could relate to character and credit above. However, as a commercial lender, your personal character really does not matter. What matters is how you have treated your previous creditors. You could be the greatest person on earth but have struggled in the past to pay other lenders. Have you shown that you are willing to ensure they get paid no matter what? It does not matter what I, as a lender, think about you personally, it only matters what I can sell about you - sell to a loan committee, to a loan or bank manager or the federal examiners. They do not care if you are a great person - they only want to see that you will not default on your loan. Thus, it all comes down to credit. Your personal credit is a past history showing your 'willingness' to pay back the people, businesses or financial institutions from which you have borrowed money in the past.

Most lenders have a minimum FICO credit score requirement. Before the financial meltdown in 2008, the minimum usually hovered around 640 FICO. However, today, given the scrutiny that most lenders are under and the increased default risks they face, that minimum now hovers around 700 FICO. If your credit score is below this minimum, most lenders will not waste their time talking to you any further as they know that they will never get your loan request approved.

Lastly, collateral. In my opinion, collateral really does not matter for a simple business loan or line of credit unless the loan is secured by business financial assets like accounts receivables or purchase orders - termed conversion of assets loans - where the repayment is not based on cash flow of the entire business but on terming those specific financial assets into cash.

But, to be honest, banks, bankers, etc, do not want your collateral. It is usually too hard and expensive to get rid of it. However, federal policies regarding commercial lending require that banks protect their depositors or investors by holding title to hard assets that are expected to have the same or more value of the cash that it lends out. Therefore, if a borrower does default on the loan, the bank does have some recourse in becoming whole again (getting its money back). The same is true for personal guarantees. If the borrower is personally liable for the loan and has collateral pledged to back the loan, it is less likely that the borrower will just walk way before doing all that they can in continuing to serviced the debt.

Therefore, when seeking business debt (business capital), do not go to your banker expecting to outline the ways you meet the 5 C's, but go there with a scenario in mind on how you (and ultimately your banker) can sell your ability and willingness to repay the loan. All other things, including collateral, will fall into place if your banker believes you will first do everything that you can to repay them as well as have the means to do so.

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