The first question I get asked as a commercial banker is What do banks really look for in a commercial loan request? Whether you are just starting your business or have reached a point where you are ready to expand, having outgrown your office or warehouse, there will come a time in the company’s venture when you find you need more funding than you have on hand. That is the time when you nervously approach your bank for a commercial loan.
You’ve probably heard the old saying that banks will only lend you money if you don’t need it, but on the other hand, do we want them to take chances with our hard-earned savings? If you think about it, the bank has a responsibility to be careful with the funds entrusted to it by the depositors, as well as offering loans to consumers and businesses. They can’t be too cautious, or they won’t make loans, and they can’t be too reckless or poor consequences will follow. Somewhere in the middle is the place where good loans are made, and entrepreneurial dreams come true. By planning ahead, you can increase your opportunity to get approval for that commercial loan.
The 5 C’s of commercial lending.
Just as diamond quality has four C’s (cut, color, carat and clarity), your bank will be looking at the five C’s in consideration of your commercial loan request.
- Capacity: Are you able to repay the loan? Obviously, this is key. The bank will be looking at your company’s credit history to see how you have handled payments in the past, and at your current debt load. Generally speaking, your debt service coverage ratio should be below 1.2 percent, meaning that you have $1.20 of income for every dollar of debt that you hold. This ratio may be required to remain in this range to avoid technical default of the loan if granted.
- Collateral: The bank will want some way to recoup its investment if you should fail to repay or go out of business. That is the purpose of collateral. Collateral can be in the form of real estate, equipment, or even accounts receivable, but you will not get full credit for the value of any of these. If you have property, that is generally considered the safest, and the bank may value it at up to 80 percent for collateral purposes. Your accounts will likely be valued at closer to fifty to seventy five percent and equipment, even lower, around 50 percent, depending on the industry and age of the items.
- Capital: How much money do you have to keep operating the business? Equally important, how invested are you (and your partners, if any) in the business? This demonstration of commitment is one of the reasons why many banks will require a personal guarantee for a commercial loan. They want to make sure that you have “skin in the game” just like they do.
- Character: This is a more intangible but highly critical factor—what is your company’s standing in the community? Do you offer great service? Are your customers and vendors happy? Credit history is part of this element, but reputation can make a difference as well.
- Conditions: This final “C” is one that you can’t control—what is the external economic climate like? If there is a prevailing risk of recession or fear of an economic downturn, you may not have a favorable response to your loan request even if you have all the other factors required. This will be exacerbated if your business falls in a high-risk industry or in an area of the country that is suffering from hard times.
Put your best foot forward.
Your loan request/business plan is like your Facebook profile (but be honest!) for showing lenders what you have to offer. They want to know that you don’t need their money, but that you can use it to great advantage. The business plan should outline what the business is, of course, but also should show that you have done your homework. Who is the management team if it is more than a sole proprietorship? Demonstrate that you have researched the target market and the competition and have a solid plan for success. If you have profit and loss statements and financials, have them audited or at least reviewed by a CPA. This will give your bank the confidence it needs to approve your loan request.