A question we regularly get asked by business owners is what do Banks need to consider before lending 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 your 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 and 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
- Earnings being generated from core business activities
- Earnings being retained in the business 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 it comes to providing lending against a business, is what actual equity do the owners have in the business?
That is; who is taking the greater risk – the business owner, or the Bank?
For example, if you have equity greater than say 40% on your balance sheet (Net Tangible Assets /Total Assets), then a lender is likely to be more comfortable, than would be the case if you only had say 15%.
A low level of equity in the business, in most instances, means there is little room to move if things start to go wrong.
It is not all that dissimilar to your home, if you have a good amount of equity, you have greater flexibility and more options than would be the case if you only had say 10% equity.
Where the gearing of the business is high – this presents additional risk to the Bank which is why they seek, additional supporting security, or more equity being created via retained earnings, or an injection of additional capital into the business by the owners.
Quality of earnings
When satisfied with the question of gearing and risk, the next question to be addressed is your track record in terms 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 to Lenders the reasons for changes in growth and earnings.
This may be due to introduction of new products lines, a changed marketing focus, a cyclical downturn, delays in benefits arising from a merger or commissioning of equipment etc.
It is important not to assume the Lenders will understand this – as raw numbers can paint a misleading picture if they lack a background story.
The quality of the business assets – 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?
- Is there a good spread of quality debtors – are collections in line with stated policies.
- What is the bad debt history? Are 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?
- Are the fixed assets well maintained?
Another key questions Banks will consider is:
- 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, to what extent are they retained to support ongoing operations and to fund future growth.
In small business, profits are often distributed to the owners to support their lifestyle, for example to purchase a home or investment property.
Whilst this approach is completely understandable, when profits are fully distributed, 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.
In these circumstances, where profits have been distributed and the balance sheet is highly geared, Banks may ask that the assets purchased using the distributed monies, be provided as security.
When it comes to lending against a business, Banks focus heavily on the historic and expected performance of the business and the quality of the assets against which they are advancing funds.
They also consider what the business and assets will be worth if things do not go to plan.
Essentially, they know that the liabilities will be real – so the quality of the assets is a key focus.
Having decided that the business meets these key criteria, the next step would be to look at the supporting policies and processes within the business that make it all happen. This will be the subject of my next post.
If you would like to learn more about lending against a business and what is required, don’t hesitate to give me a call on 0409 409 310