Basics to bank lending

“I need more cash,” is a phrase often used by business owners. Banks are the traditional source of that cash. It is worth reminding ourselves of two often overlooked “basics” about bank financing especially given the recent trends in credit markets and the general hesitancy of financial institutions to loan money.

The first basic principle in bank lending is source and use. What type of loan do you require and why? The first type of loan is a traditional line of credit (LOC). LOCs are traditionally a bank financing product designed by banks to help businesses through the natural cash flow cycles in their business or through short burst growth cycles. A classic example is that a LOC would support a manufacturing business’ cash requirements through the process of buying new raw material, producing a finished product, selling the product, and collecting on the sale. The second type of loan is a traditional term loan. Term loans are designed by banks for new investments requiring upfront cash for new equipment, launching of a new business unit, or a geographic expansion. An example would be when a manufacturer needs to purchase new line equipment, open a new plant location, or launch a new product.

In essence, “I need more cash” is effectively an incomplete sentence. Like most other big decisions in business, the critical piece to communicate with your executive team, advisors, and banker is “I need more capital because… or to accomplish…” With a clear purpose and vision, the proper financing structure can be developed to match the requirement with terms and conditions that are appropriate to the exact need. In short, a sources and uses analysis will aid all involved in developing a proper financing structure.

The second basic principle in bank lending is assurance of repayment. Bankers will always insist on a secondary source of repayment. Countless times banks have shared their perspective that that the primary source of repayment (a business’ net operating income) is one bad decision away from evaporating. A classic example is when a manufacturing business secures a term loan to launch a new product. All materials are purchased and manufactured but the product turns out to be defective. Suddenly the primary source of repayment (income from sales on the new product) is no longer viable. The business likely will default on the terms of the loan. The most common secondary assurance is the owner’s personal guarantee. Banks want to insure they will be repaid. The financial health of the borrower must be evident and clear. Excellent financial reporting can outline all potential repayment sources through the balance sheet and personal financial statement.

In conclusion, the greatest success for a business owner occurs when a full picture of the business including past, present, and future financial statements are presented to the banker. Presenting the business as a case study to a series of bankers and interviewing them to understand their proposed solutions is critical to success in lending. Develop a personal connection with the banker and have them share in your vision and passion. At the end of the process, a business would ideally create competition among financial institutions and have a number of different options when resolving the “I need more cash” phrase.

Written by:
Andrew Ruff
TGG Accounting

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