Billy’s Twentieth Law -- Banking Paradox Two: Just because your business is bankable, doesn’t make it viable!

The surest way to ruin a man who doesn't know how to handle money is to give him some.

·         George Bernard Shaw

Last week, we looked at banks’ lending criteria.  This week, we look at the reality of a small business loans.  Before the nineties, a business loan was scrutinised by a business banker.  This is a time consuming process performed by a highly skilled individual.  (Or so business bankers would have you believe!)  Wells Fargo Bank in the Unites States made an interesting observation.  The best predictive indicator for the repayment of a small business loan was not the business plan, but rather the credit worthiness of the prospective business owner.  People who managed their personal finances well were more likely to repay their debts than those who did not.  

This created an interesting dynamic in the small business lending arena.  Personal credit history replaced the brilliance of a commercial credit officer.  Personal lending criteria replaced business-lending criteria when granting smaller loans. 

When this concept first came to Canada, it was revolutionary in banking circles.  Banks could speed up their responses to smaller business loans simply because it is easier and faster to do a credit check than to analyse a business plan.  I remember that the first loans were up to $35,000.  BMO (if memory serves me) increased this to $50,000. 

Over the years, this seems to have worked in Canada, as the loans are getting quite large before a commercial credit officer takes over your account.  The refusal rates were lower, default rates dropped and the approval process was faster and simpler.  The bank did not require a time consuming business plan, which includes the cash flow forecast.  Entrepreneurs were happy and the banks were happy. 

There is one problem with this situation.  Many businesses are financed without the scrutiny that used to accompany a business loan application.  The banks do not distinguish between a loan repaid with the proceeds of the business, the contributions of a willing spouse or even the redemption of RRSP’s, investments or sale of the house.  The bank just knows that it was repaid for the loan.

In our business, we have seen many people scrambling to repay lenders using such sources.  We have seen marriages come under huge financial stress, as one partner finances a business that takes all of the other partner’s time and efforts, as the enterprise sinks deeper and deeper into the financial abyss. 

I cannot say that I blame financial institutions.  Analysing a business proposal takes time and expertise.  The cost of administering a small loan, given the small margins the bank receives on a smaller loan leads to such banking policies.  Many people however are unaware of this.  Some people see bank financing as an endorsement of the business or the concept.

Unfortunately, I don’t have an answer.  I don’t think it is realistic to hold the bank responsible for the future of an enterprise, yet most people have no idea how to objectively evaluate a business, never mind a business concept. 

So, as they say, Caveat Emptor.  However, let this lesson be to you.  Your financial institution really wants you to succeed, however; in the final analysis, they want repayment even more.

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.

Billy's Eighth Law: When it comes to the bank, they guy who writes the ads ain’t the guy that writes the loans.

Business owners, media, politicians and the public in general, are in the dark when it comes to business banking. I am not talking about complex derivatives, credit default swaps and currency futures. These are incomprehensible to most bankers, hence this little thing called the credit crisis!  (I actually know what those things are and they never help me in my dealings with small and medium sized enterprises.)  No, I am talking about good old fashioned borrowing and lending.

Banking, to quote the Canadian Bankers Association, is a low risk, low margin, high volume business.  Banks raise money two ways...debt and equity.  A bank incurs debt when it issues a bond or takes deposits from customers.  A bank finances through equity by issuing shares or retaining earnings in the business.  The government requires a certain ratio between debt and equity known as the reserve requirement.

But let's make this easy... we will start-up our own bank.  We'll call it the Entrepreneurship Bank and lend money to struggling entrepreneurs who want to start and expand their businesses. 

Step One:  Capitalize the Bank

To begin we capitalize the bank with $100,000. (It's a small bank for small business)  The rules allow us to raise $1,000,000 in debt.  This is a total of $1,100,000.  We keep side $100,000 in cash float, and have one-million dollars left.  We can now begin to lend money.

Step Two:  Borrowing and Lending

We can now look at the bank’s revenue & expenses under the following assumptions.

Our lending rate averages 6%.

•  We pay, on average 2% on deposits

•  We generate $20,000 in fees

•  Our overhead costs are $30,000
 

We can look at the income statement:

 

 

Notice, we have a profit of $30,000 per year…not bad for an investment of $100,000.  However I have forgotten one small detail...bad loans.  Banks and other financial institutions must make reserves for those loans that will never be repaid.  When I ask participants in small business seminars for an estimate of the percentage of loan loss (sometimes known as PCL, provision for credit loss), they usually tell me, “I guess it’s around 10%” In this example, if the bank would lose $70,000, wiping out most of the capital in the bank and forcing it into insolvency. In our example, a loan loss of 3% would leave the bank without a profit and 4% would create a loss!
 

In real life, the numbers are much larger, the Net Interest Income is a bit higher and the loan loss provision is between .5% and 1%. Regardless, if a bank makes a net profit of 2% on loan assets after loan loss, they are doing well.  Banks are lenders, not investors. If your bank seems to be somewhat conservative, then it is another reminder that banking is a low risk, low margin high volume business.  
 

Understanding your bank, and how bank financing works, is essential if you want to be successfully apply for bank financing.  Unfortunately, most bank lending to Small and Medium Enterprises...loans under $250,000 are written by personal and not commercial lenders,  The implications of this fundamental flaw in the banking system is a topic for another law. 

So the next time you apply for bank financing remember, your banker must be right 99% of the time in order to preserve his or her bank.