A question regularly asked by business owners is what do Banks need to lend against a business?
Another common question is – what key criteria do I need to meet so that I can have my home removed from the Banks security arrangements?
The answer to this will vary widely depending on:
- How long the business has been established
- The industry sector in which you operate
- Your track record in terms of sustained growth and profitability
- The amount of equity you have in the business
- The quality of the assets in the business balance sheet
- Past loan and account conduct
- And more
Lending Against a Business – Your Track Record is Critical!
When lending against a business two key questions Banks ask is:
- Who are we lending to?
- What is their track record?
A good track record extends to things like:
- Your background, experience and how long you have been in business
- The business history of sustained earnings and profit growth
- Whether earnings are generated from core business activities
- Retention of earnings to fund ongoing activities and future growth
- Your credit and/or loan repayment history
- Past experience across different economic cycles
Lending Against a Business – Who is Taking the Risk?
A key focus of Banks when lending against a business, is what equity do the owners have in the business?
That is; who is taking the greater risk – the business owner, or the Bank?
For example, a business with greater than 40% equity, (Net Tangible Assets /Total Assets), will provide more comfort to Lenders , than than one with only say 15%.
A low level of equity, in most instances, means there is little room to move if things start to go wrong.
It is not dissimilar to your home, where if you have a good amount of equity, you would have greater flexibility than if you had only say 10% equity.
Where the gearing of the business is high – this presents additional risk to the Bank, which is why they often seek:
- Additional supporting security
- Increased retained earnings
- Or an injection of additional capital into the business by the owners.
Quality of Earnings
When satisfied with the gearing and risk, the next focus is your track record of revenue growth and profitability:
- Have earnings and profit grown consistently over time?
- Are the earnings from core business operations?
Most businesses go through different cycles. It is therefore important to explain the reasons for changes in growth and earnings.
This may be due to:
- The introduction of new products lines
- A changed marketing focus
- Cyclical downturns
- Delays in realising the benefits arising from a merger
- Longer timelines than anticipated installing and commissioning new equipment
- Etc
Raw numbers can paint a misleading picture if they lack a background story. It is important to explain the reasons for changes within your business.
What are we Lending Against?
When lending against a business, Banks look for comfort as to the quality of the assets in the balance sheet:
- Are the assets related to core business activities?
- A good spread of quality debtors – collections in line with stated policies
- What is the bad debt history? Are the debtors insured?
- What is the quality of the stock and is it readily saleable
- Are stock levels and turns appropriate for this type of business?
- Do robust stock management and tracking processes exist?
- Are loans listed as assets collectable?
- How well the fixed assets well maintained?
Other key questions Banks will consider are:
- What will the assets be worth in a distress situation?
- Who would be the potential buyers be at this point in time?
Are Earnings Reinvested in the Business?
Another element Banks will examine is what happens to profits generated by the business?
Crucially, are sufficient earnings retained to support ongoing operations and fund future growth?
In small business, owners often distribute profits to support their lifestyle, for example, to purchase a home or an investment property.
Whilst completely understandable, it often results in the company balance sheet being highly geared.
It can also mean insufficient funds are available to take advantage of opportunities, fund growth or ride out difficulties when they inevitably arise.
Where the balance sheet is highly geared, Banks may ask that the assets purchased using the distributed monies, be provided as security.
Summary
When lending against a business, Banks focus heavily on the historic and expected performance of the business.
They also consider what the business and assets will be worth if things do not go to plan.
The liabilities will be real – so the quality of the assets is a key focus.
They will look at the supporting policies and processes within the business that make it all happen.
If you would like to learn more about lending against a business, don’t hesitate to give me a call!
