Understanding the Banker's Formula: Part II
By Linda Plater | September 30, 2001
You've been turned down for a loan -- slam, ouch! Then it's time to get up, understand what isn't working, and move on.
Understanding how to secure financing from the bank is not an obvious or simple task. Both startups and more mature companies in growth mode look to banks for similar reasons, usually for operating lines of credit that will give them the flexibility to build equity in the business. Unfortunately, many newer business owners only realize that their numbers don't "add up" to what the bank wants to see until they have received several big fat "NOs" in response to credit applications.
By making errors or omissions on the financial statements applicants give to the bank, entrepreneurs find out the hard way how not to get a loan.
It's true, there are common balance sheet mistakes that bankers see over and over again. But it seems that no one takes the time to explain these errors in detail or ask how to avoid them. Everyone is too busy; this includes the business owner scrambling for money and the banker eager to get reliable clients. So CanadaOneâ„¢ decided to look at why this happens, to give our readers an edge when you begin negotiating with your bank.
Common Balance Sheet Mistakes
#1 - No Relationship with Your Lender
It's one thing to recommend that an entrepreneur establish a relationship with a lender but what does this mean in financial terms? It's not enough to get to know a mid level branch employee on a first name basis. You've got to educate the banker about your business and share your financial plan that details at least 3 months in advance. Every month provide a new month to the banker and remove the old one. This way your prospective lender will know exactly where you've been and where you plan to go even before you ask for the loan. A business that prepares for a loan in the future before it needs the cash will be in good shape when it comes time to ask for the loan, unlike unprepared companies up against the wall when a cash crunch hits.
If you get the bank involved in your cash planning, they might be more apt to seriously consider approving your loan request. So let your bank know in advance if you expect to need a line of credit or longer term financing for an equipment purchase or lease.
Smart Tip: Share your financials with your bank. Educate them on your business, its past profitability and future plans before you need financing. Involve them in your cash planning.
#2 - Weak Cash Planning
Errors banks usually see boil down to a lack of preparedness in cash planning. While most investors have a high tolerance and are prepared to wait for profit, suppliers have zero tolerance for not getting paid on time. For many small businesses, it seems like their receivables go right out the door to cover payables, often running them into the red.
Your lender, a valuable partner and supplier of cash - not an investor, is particularly interested in how you manage your cash flow. Banks want to make sure that they get their money back. If your financials don't demonstrate a high likelihood the bank will get repaid with interest, then you're in trouble.
This is where the ratios come into play. Your debt to equity ratio might indicate to the bank that your loan is unserviceable.
Smart Tip: Make sure your financials demonstrate a solid cash plan.
#3 - Stretching the Truth
It may seem like you are just stretching the truth a little bit, but if the banker finds a difference between your numbers and those on your credit file, the likelihood of your loan being approved will be seriously damaged. Your personal credit file is a key component of the bank's decision for loans under $100,000. When they review it the banker will look to see that you do not have any late payments reflected on your record, and they will also expect it to match the information that you included on your application.
The information you provide on your loan application should match what the banker will uncover when pulling up your credit file and various other records. No matter how tempting it may be, stretching the truth will not increase the odds that your business will get the bank loan or line of credit that you want. You also need to provide your overall business picture including all forms of your debt: credit cards and lease payments. Once the lender sees the complete information only then can they make a decision.
Smart Tip: Be honest and accurate when providing financial information to your banker.
#4 - Unrealistic Expectation of Profitability
You're running a hot enterprise or so you think. Quite possibly the bank doesn't share your optimism. Your statements might show the potential to earn great profits, but your performance over the past could suggest otherwise. And if your past financials don't demonstrate viable pricing, sector growth and a believable market penetration, chances are that your banker won't buy into your vision. It's important that the bank shares your financial vision for the company.
ABA's Senior Consultant, Ray Belanger stresses the notion that, "Profit is opinion but cash is fact." From the banker's viewpoint, this means that proof of actual cash in the business is much more important than a company's potential to become profitable. Again, this needs to be reflected in numbers on the financials you provide to the bank.
Smart Tip: Support all growth and profitability claims with solid math, contracts in hand and industry research. Make sure the bank agrees with your projections for profitability.
#5 - Presenting Past Records instead of Future Projections
Most applicants provide income statements prepared by an accountant to the bank. These statements detail historic information that accounts for where the money came from and where it went. Although the bank is interested in past performance, what a business needs to do is build proforma financial statements for a case that supports future success.
Your financial forecasts should be forward thinking and show all aspects of your capital-- how much, where it comes from and how you will pay for it.
Smart Tip: Provide solid forward thinking statements that show all aspects of your capital planning.
#6 - Unsupported Operational Efficiency
You might tell the bank that your business is efficient and has potential to earn huge profits, if only it gets an injection of cash. Your lender will nod and look back to your financial statements to find solid evidence of your claims. That's why your financials need to show precisely how your company is structured and how cash is allocated to generate profits. How your business plans to distribute capital is important to the bank. Does your company plan to keep the cash, buy equipment, pay off your receivables? Do you really need to borrow; where do you plan to borrow and how much interest do you plan to pay?
Do you understand the market and how you compare with similar businesses? This is where benchmarking comes into play. Some consultancies provide benchmarking tools to help companies to position their financial planning in line with their market sector. It's valuable to include industry averages to shape your balance sheet so that you are in the right ball park. Industry ratios can be found at the library in the standard industrial codes (SIC). Caution though, SICs are dated and may not accurately reflect new economy businesses. Another tool Performance Plus www.strategis.ic.gc.ca/sc_mangb/sme/engdoc/homepage.html developed by Industry Canada's Strategis can help you to position your company.
Smart Tip: Demonstrate the company's efficiency and benchmark it within the industry.
#7 - Reasonable Decision, Wrong time
To rent or to lease, that is the question. This depends on the stage of business you are in. Are you more concerned about cash flow or profitability right now, what about six months from now? Leasing is easy on cash flow, hard on profit; purchasing is the opposite. If you don't understand the implications of your choice you may be caught because you need to find the optimal solution as it pertains to securing financing. Look at the time you buy assets for the business.
Lots of equity and minimal positive cash flow is not a good formula for borrowing because you can't service the debt.
Smart Tip: Get sound financial advice on the best time to lease or buy business assets.
#8 - Lifestyle Business Decisions
As an entrepreneur, you will likely be thrilled when your business starts generating enough cash for you to enjoy a comfortable lifestyle. From the banker's perspective, taking cash out of the business could be seen as destroying capital.
On the balance sheet, profits paid out to the owner in dividends, management fees and bonuses are all red flags. You should expect the business to support you, but your banker doesn't want to see you draining the business of valuable cash and resources to fuel your personal lifestyle. Similarly, shareholders loans on the books, where you owe the business money, are not favourable when presenting your financials to a banker. If you are looking for a bank loan, you want to show profits and retained earnings on the books.
Smart Tip: Leave enough profits and retained earnings in the company to keep your banker happy.
#9 - Premature Tax Optimization
Of course, no one enjoys a tax bill at year end. If the cash is available business owners always have the option of reinvesting their net profit back into the business. However, this decision could put you on shaky footing with your banker should you apply for credit. Reinvesting your profit to reduce taxes shows less profit on your books which makes the business look weaker than it actually may be when it comes to paying off debt.
Remember point two, where we explained how the bank uses the debt to equity ratio to determine your ability to service a debt? This also applies to tax optimization. A lower net profit at year-end will mean that you pay less tax, but if you have any concerns about your ability to get financed you may want to put tax optimization second on your list of financial priorities.
Smart Tip: Seek professional tax advice. Explain to your accountant that you plan to apply for a loan and your balance sheet needs to prove that you are able to service your loan.
#10 - Not Paying Yourself
While the bank doesn't want to see you gouging the business to support a cushy lifestyle, they don't want you to work for free, either.
Many owners proudly sink all earnings back into their business and deny themselves of a salary. Banks, however, want to see that the business is profitable, i.e. if you needed to pay someone to do your job, what would that cost and would you still turn a profit if you pay salaries? If not, then you are not a good risk for a lender.
Also on CanadaOne, be sure to check out Financial Ratios Revisited and our new Ratio Calculator .In the first article in this series, Understanding the Bankers' Formula, we outline the factors that a banker considers when evaluating loans and also reveal some balance sheet "must-haves" to help your business get in shape for lender scrutiny.
The information in this article was compiled with input from:
- Ray Belanger, Consultant
- Robert Gold, Managing Partner, Bennett Gold Chartered Accountants.