Billy’s Nineteenth Law: A Viable Business is not necessarily a Bankable Business

Neither a borrower nor a lender be, For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.

Hamlet Act 1, scene 3, 75–77

This is the second of my three laws of banking.  In the first banking law (Law Eight, for those of you who are keeping track) we discussed the dynamics of banking from the lender`s perspective.  In this law, we examine how the credit officer (also known as the Loan Arranger) makes his or her decision.  Banks often use what is called the five C`s of credit when determining whether or not to advance loan proceeds.  These are:

Capacity (Cash Flow): This represents your ability to repay the loan from internally derived sources.  The Cash Flow Forecast is one critical document in influencing lender`s decision.

Capital:  This represents the amount of money the owners have invested, or retained in the business.  We measure this by calculating the Debt to Equity Ratio.  Banks don`t generally like having more at risk than the owner.  

Collateral:  This is the bank`s security should the loan fail.  Internal security is found within the business.  It can include inventory, accounts receivable and equipment.  External security is pledged by the borrower from assets outside the business.  This could include personally held stocks & bonds or real estate.

Conditions:  These are the terms and conditions requested by the borrower.  The amortization period of the loan is one example.

Character:  This represents the personal characteristics of the lender or lenders.  There are two distinct aspects…the management or business skills of the owners and the credit history of those same borrowers. 

Notice, that the notion of business viability is absent from the decision making.  Capacity (Cash Flow) measures the historic nature of the business, and possible lends itself to viability, however; the remaining criteria have little to do with the overall viability of the business concept and the ability of the owners to execute the requisite strategies.  

Some businesses are not conducive to bank / debt financing.  Businesses requiring a great deal of development time prior to operations (developing a computer application for example) have no security what so ever.  An owner may take out a personal loan and invest it in the business, but this is very different from a true business loan where the bank grants the loan on the strength of the business.

Some entrepreneurs lack personal resources.  This reduces capital, increasing the debt to equity ratio and thus making the loan more difficult to approve.  Other entrepreneurs request term loans for items that quickly lose value (collateral).  If you were a banker, would you rather approve a loan for a car or a computer lab?  Computers lose their value very quickly, reducing the security value and thus making the loan more risky to the financial institution.

Over the years, I have worked with many entrepreneurs and ‘pre entrepreneurs’ and one recurring problem is the lack of start-up financing.  It is not appropriate for the financing to all come from debt sources, including the bank.  Non-traditional sources of equity such as crowd sourcing and even debt/equity hybrids are in their infancy. Until this is more common, the challenge of financing will remain difficult and therefore the borrower must understand the lender.  Always remember:

It takes more than ideas to start a business, it takes capital.  That’s why we call the system capitalism and not idealism!

 Next time the opposite dilemma loans granted to non-viable business.