Commercial Banks: Conservative Institutions

Money is a commodity like any other, its price is the rate of interest charged. As with any other desirable asset, the price of money rises in response to increased demand, or as supply falls. In other words, when farmers have a year of poor crops, produce prices increase; when loan money is tight, interest rates rise.

As a commodity, however, money does have some unique characteristics. While there may not be a direct connection between what happens to a California lettuce farmer and a Brazilian coffee grower, what happens to money impacts virtually every other commodity.

Greatly increased money supply devalues the dollar in a process we all know painfully as inflation, where more and more dollars buy less and less in the way of goods and services. Unlike other commodities, money loaned is not meant to be permanently consumed. When it is purchased, or borrowed, money must be paid back with interest on a pre-determined schedule.

The single greatest source of business money, or "credit" as it is also called, is the nation's banks. These financial institutions have a reputation for being very conservative when lending money.

That is as it should be. After all, banks get their money from thousands of people who demand a guarantee that their money will be safe and available when they need it. The last thing depositors want is a bank handing out cash in unsafe loans that may jeopardize accounts, and even the existence of the bank itself. That became abundantly clear during the savings and loan debacle in the 1980s -- a mess that is far from being cleaned up, and one that will be costing Americans well into the next century.

Centuries of experience with both human nature and banking has produced federal and state government regulation of the banking system. Official oversight requires periodic audits and checks, demands certain minimum capital availability at all times, and hopefully keeps bankers and banking honest.

Where Are They When You Need Them?

Present operational policies imposed on American banking -- stronger protection for depositors, tighter official regulatory standards due to vivid memories of disastrously lax lending by S&Ls -- now make it virtually impossible for even a mildly poor business credit risk to obtain a bank's consideration, much less a loan.

While many businesses benefited from the US and European economic recovery starting in the second quarter of 1994, these same companies have had great difficulty finding working capital to expand and meet new demand.

"There's supposedly billions of dollars out there, but not much of it is going the way of small businesses that have sales of less than$2 million annually and a need for a $500,000 loan," said Miles Spencer, a Connecticut investment banker specializing in small business loans, in a November 1994 interview with the Wall Street Journal. 97 percent of America's18 million businesses fit the definition of "small business."

Typical is the predicament of Hydrokinetic Designs, Inc. of Coral Gables, Florida, a producer of popular twin nozzle shower heads. Although the company's sales have followed the home building upsurge and more than doubled in1994, Hydrokinetic was turned down twice in 24 months for bank loans. Banks would not lend against the company's $450,000 in inventory, demanding instead fixed assets as collateral. Unfortunately, the company lacks such assets because they subcontract most of their work to other manufacturers and don't need real estate and machinery. This lack of capital has severely limited growth, forcing Hydrokinetic in one case to decline the order of a large retail chain because they could not finance production of a rush order of 10,000 additional units.

The Journal reported that banks uniformly were declining loans requested by companies without fixed assets, as well as newer businesses with little operating history, and older firms that had suffered economic setbacks.

Meanwhile, the biggest companies are finding it much easier to access banks, equity capital and institutional lenders such as insurance and pension funds. But potential small business borrowers are left out in the cold. In response to an August 1994 Federal Reserve survey, senior loan officers of only 6 out of 57 banks contacted said they had eased credit standards for small business borrowers. At the same time a year earlier, only 7 out of 60 banks said they had eased small business credit.

In spite of a special push by the federal government to increase small business loans in 1994, only 10 percent of banks contacted said they agreed. On August 30, 1994, the US Small Business Administration launched a new program guaranteeing 75 percent of qualifying small firm's revolving credit lines up to $750,000. SBA predicted the program would generate over $1billion in new loans in the first year, but in the first four months only five loans totaling $1.5 million were made. An SBA official admitted most bankers are highly reluctant to make loans secured by inventory and receivables, rather than plants and equipment.

What Banks Want from a Borrower

In spite of a gloomy outlook, banks are making loans, and your business may be the one that successfully connects with the right banker at the right time. When you approach a bank, always keep in mind that bankers don't really care too much about what your intended use for borrowed funds might be. What they want to know is whether or not you can demonstrate a realistic ability to repay the loan, and what type of tangible collateral is available as security for the loan -- preferably hard, foreclosable assets like real estate, buildings and machinery. Loan length does relate to the proposed use, however. Short-term loans, when available, are generally restricted to seasonal inventory needs, receivables or working capital. Long-term loans are used to fund plant expansions and improvements, major equipment purchases and real estate. Most standard bank loan agreements allow the bank to "call" the loan at their option at any time, and most require a personal guarantee from the business owner as well.

Here are the major points a banker looks for when reviewing a business loan application:

1. Cash flow. A consistent record (a minimum of three years or more)of available cash flow; net profit is not nearly as important as receivables that are consistently paid on time.

2. Strong collateral. Even with a good cash flow, bankers won't take receivables and inventory as security for a long-term loan, but they might-- just might -- consider them as backing for a line of credit; but you will have to pay it off within a year or less in order to qualify for a renewal. The collateral must be the kind that retains its value over the life of the loan, because banks want something of value to be there if they must foreclose.

3. An established history of increasing profits and retained earnings. Bankers want to lend to profitable, going concerns that can produce plenty of proof of repayment ability; and they don't want profits siphoned off to unreachable places like an owner's personal income.

4. A major interest in the business by the owner. Banks want clear evidence the owner: a) has good credit, business-wise and personally; b) plows profits back into the firm; c) has a large personal equity investment in the firm; d) has a high personal net-worth exclusive of the firm's status; e) has not stripped the firm by taking profits that should remain in the company. Income tax returns for the last two to three years will normally be required.

5. Financial projections. Show why this is a loan good for your business, and that you have thought through what the consequences of failure will be.

You want to give the banker all of the information necessary to increase his or her comfort level; you want the banker to be able to approach the lending committee and confidently recommend approving your loan application.

The Bottom Line

What banks want is good character, good credit, good capital investment, good capacity to repay, and good collateral. And you may well be muttering to yourself, " If I had all those things, I wouldn't need a bank loan."

Even if your business (and you) fail to meet all these stringent loan standards, you may still be able to find a hungry, aggressive bank some where looking for loans and depositors, one willing to lower requirements a little. The unusual lending institution fitting this description will be a smaller local bank anxious for growth, but certainly it won't be the branch of a massive banking conglomerate with an unyielding policy against potential loan headaches, however slight.

If your business balance sheet is stained with any financial problems, it won't take an astrologer to predict your bank loan chances correctly. Money may be "tight" in general, but your chances would be even tighter.

While you should always try, be prepared for the reality that bank loans are not likely to be the answer to your financial prayers.