ABA Offers Tips to Get Small Business Loans

ASSESSING THE BANK LOAN OFFER

WASHINGTON, Feb. 17 /PRNewswire-USNewswire/ -- The following is a white paper by Robert C. Seiwert, Senior Vice President and Director of ABA Center for Commercial Lending & Business Banking.  Once you have a loan offer, how do you know whether it's the right one for your firm? Start assessing the loan package by asking the following questions:

1) Is this the appropriate type of loan?

In order to select the appropriate loan type ("facility") and term, it's critical that you and your banker understand the real reason your firm needs to borrow money. Short-term funding needs (such as the purchase of office supplies) should be supported by a small business credit card or a bank line of credit. Intermediate or long-term funding needs, (such as the purchase of equipment or to fund permanent working capital) should be supported by a term loan.

The reason that a firm needs to borrow money may or may not be the same as the purpose of the loan (i.e., how the loan proceeds are going to be used). A firm that wants money to support working capital requirements (such as accounts receivable or inventory) may need these funds because the firm:

• is experiencing a slowdown in its asset conversion cycle (the conversion of inventory into accounts receivable and then cash); or
• needs to build up seasonal inventory to match the selling season; or
• is experiencing a non-seasonal growth in sales and therefore needs to permanently build up the level of accounts receivable and inventory to support this new level of sales; or
• utilized funds that would normally support the firm's working capital needs on equipment purchases or dividends or bonus payments to the owners.

Each of these borrowing causes is different, but the loan purpose is the same for all of them. The source of funds to repay the loans will also be different. If the borrowing cause is to build up seasonal accounts receivable and inventory for your selling season, then your firm needs a short-term credit facility. Funds will be available to repay the loan at the end of the selling season when the temporary buildup of accounts receivable will convert into cash. If your business is experiencing rapid growth and the accounts receivable and inventory requirements are not seasonal, but permanent, then your firm needs a longer-term credit facility. Funds to repay a permanent buildup of core inventory and accounts receivable will only be available if the firm is profitable over a number of operating cycles.

It's critical for the loan facility type to correspond to the borrowing cause and expected loan repayment source. If your firm really needs permanent working capital and you or your banker diagnose the borrowing cause as a short-term need to build up working capital, a mismatch will occur between the nature of the asset being financed (permanent working capital) and the source of funds available to repay the debt obligation. Since the borrowing need was for a permanent increase in accounts receivable and inventory, there will be no seasonal decrease in these assets that will provide the funds necessary to repay the loan. The unfortunate result of the mismatch between loan facility type and borrowing cause is that your firm will not have the funds necessary to pay off the loan when it's due and it has now become a candidate for the bank's problem loan list.

2) Is the loan rate appropriate for this type of credit facility?

Perhaps you've heard other small business owners bragging about the great loan rate they got from their bank. What those borrowers may not have mentioned was that they had to pledge all of their assets to get that rate.

Banks set their loan rates based on:

• the perceived loan repayment risk;
• the term and type of loan arrangement; and
• the profitability of the entire banking relationship.

A borrower who provides the bank with three to four times the amount of collateral required to repay the entire loan balance substantially reduces the bank's risk. This over-collateralization allows the banker to reduce the cost of the credit facility to the borrower.

So how do you ensure that you are getting a fair borrowing rate for your loan? First, look at the costs of the loan facility, not just the rate. Borrowing costs can be both financial and non-financial. Financial costs can include: loan fees, compensating balance requirements, outside third-party expenses, ongoing business reporting requirements related to the loan and, of course, the interest rate.

Non-financial borrowing costs can be just as important, if not more important, than the financial out-of-pocket expenses of the loan. Non-financial borrowing expenses include: the type and flexibility of the loan facility's covenants, the amount of collateral needed to obtain the loan, and the amount and type of guarantees required by the lender.

It's a good idea to apply for your loan at the bank that has your operating accounts. Your primary bank is in the best position to give you a great deal since your firm provides them with multiple revenue streams (and hopefully, profits). They also have the most to lose if you choose to move your business to another bank. If the financial and non-financial costs of the loan facility are not agreeable to you, then shop around. There are over 8,000 banks in the United States and one is certain to be right for your business.

3) Is the bank making a reasonable request for collateral and guarantees?

Bankers look for both "primary" and "secondary" sources of loan repayment and for the sake of your business, you should, too. Smart business owners understand that now is the time to think about alternative repayment sources, not when their business gets into trouble.

For most loans, the primary source of loan repayment will come from excess cash generated by the business over one or more operating cycles. Secondary sources of loan repayment will be in the form of collateral and/or loan guarantees. The key question you need to address when reviewing the loan proposal is how much collateral, and what amount of guarantee, is enough for this loan arrangement, given our firm's financial track record, experience in the industry, ability to generate cash, and prior repayment history?

The risks of over-collateralization to your business and personal financial health are real. If things don't go as planned and you're not able to pay off the loan "as agreed," or if your firm is growing rapidly and the bank decides not to continue funding that growth, you have put your firm at financial risk by over-collateralizing the loan. No other bank will be able to help you because they, too, will need a viable secondary repayment source. Unfortunately, you won't have any collateral available.

It's very easy to make a loan decision when you have four times the collateral or loan guarantees that you need to cover the loan. It's tougher when you don't. You and your banker need to make a judgment call as to what is appropriate given your firm's current financial situation and the current state of the economy.

4) Are the proposed loan covenants appropriate?

Understand that banks will want loan covenants as a part of their loan package. The key question is whether you have the flexibility to operate your business without a banker looking over your shoulder every minute of the day.

When a banker makes a loan, he has expectations about the financial condition of your business. If the financial condition is too "out of kilter" with these expectations, the bank will consider its loan position. This is appropriate since the bank made the loan based on your firm's past track record and its financial projections for the future.

How tightly the bank structures your firm's loan covenants, however, is always open for negotiation. You might find that a higher priced deal or one that involves pledging more collateral is a better deal if it allows your business to operate without stringent loan covenants.

5) What experience does the bank have with firms in your industry?

It's a good idea to apply for loans at banks that specialize in your industry. Banks that are inexperienced in a specific industry often over-collateralize loans. They ask for more guarantees and covenants than they really need as a cushion because they don't understand industry risks. As you look at competing offers, you'll see which lenders understand the risks of your firm, the industry in which it operates, and whether those risks have been appropriately mitigated through collateral, guarantees and appropriate loan covenants.

Another reason to deal with banks that have experience in your industry relates to the financial advice they can offer. Because these banks work with firms facing the same industry-related problems as those that may challenge you, they're in a better position to provide helpful advice and financial products tailored to your needs. Many times, the advice a banker gives is far more important than the product or service they sell. Seek a banker who can give financial advice that will help you survive and thrive in today's economy. In turn, you should reward that banker with your business and your loyalty.

Lending is an art, not a science. The best way to ensure that you get the best deal for your firm is to have a healthy two-way dialogue with your banker that focuses on the appropriate answers for your business to the above questions.

Robert C. Seiwert is a Senior Vice President of the American Bankers Association. Prior to joining the ABA, Mr. Seiwert was a banker for over 30 years, serving as President and CEO of a high-performing community bank and Director of Commercial Marketing for one of the nation's largest financial institutions.

Note to Editors: In light of President Obama's recently announced $30 billion small business lending program, the American Bankers Association is offering tips for small business owners. The above white paper, written by a former commercial banker, gives small business owners a rare glimpse into how bankers think and is intended to help them develop a mutually beneficial relationship with a bank, prepare to get loans, and evaluate offers. The above is the sixth paper in a series. The first five can be found at http://www.aba.com/Press+Room/PR_Small_Business_Issue.htm. The seventh and final paper will be released in the next two weeks.

SOURCE American Bankers Association