Loan underwriting is the process the lender goes through to decide whether to approve a loan lenders
use the five C's of credit when deciding whether to make a loan.
The first and most important is character.
I like to use the word credibility for this.
It includes your business reputation education professional credentials and personal integrity.
You may need to provide references for the lender to check all financial transactions are built on trust.
Find ways in the application materials to prove why the lender can trust you to be a good business partner
and pay back the funds.
How you treat the bank staff and I mean all the bank staff not just the business officer matters.
When I worked at community banks we were willing to fire customers that disrespected tellers both borrower
and lender when with a good relationship here's a link to a good article in U.S. News and World Report
on the five C's of credit.
I was a source for the article and talking about the importance of character and credibility capacity
is your ability to pay back the loan.
Profits are nice but lenders underwrite on cashflow.
I'll show you their main metric for this on the next slide.
A credit analyst will take your tax returns or financial statements and do what's called a financial
statement spread.
It's basically putting your financials or tax forms in Excel to do financial analysis capital analysis
make sure you are invested in the business or its assets enough to protect the bank a very important
ratio for measuring this is the loan to value ratio which I'll discuss in a later slide.
Debt to equity ratios determine whether you've over leveraged meaning you have too much debt.
Expect to be required to make a down payment of 20 to 25 percent for commercial real estate loans conditions
referred to the financial health of you your company your industry and the economy and owner's personal
financial woes suck the health out of their company.
Conversely a financially strong owner is a source of strength for the company.
Lenders are more willing to lend when an industry or economy is financially strong finally.
Collateral is the quality of the assets you pledge for repayment.
This may be less important than you may think for bank loans.
I talked earlier about how hard money lenders underwrite their loans based on the collateral and less
on repayment ability.
Banks lend tight spreads to their cost of funds and high loan to values on assets.
Any hiccup in loan repayment can cause a profitable loan to become unprofitable.
That's why I listed the other sees with credit higher than collateral your collateral is only important
to a lender when you can't pay them back from cashflow.
There is a sixth see that I didn't put on the slide that has more to do with your lender than you.
It's the lenders loan concentrations.
Diversification in a bank's loan portfolio reduces risk just like a diverse set of investments reduces
the risk of a personal investment portfolio.
Banks have concentration limits in their credit policies.
These limits promote geographic industry or collateral diversification when lenders are nearing a limit
they will allocate their scarce capacity only to the strongest borrowers.
For example if a bank has already made a lot of loans on storage units they may be more picky on storage
unit loans going forward since they already have a lot of capital at risk to that industry.
In that case the lender should give decent borrowers the it's not you it's me speech when declining
alone.
Those borrowers have a good chance of being funded by another lender.
The big question a loan officer has to answer is how will the borrower pay back the loan.
The Better Business can show this to the lender the better the odds the business will get the loan.
The answer is providing multiple sources of repayment.
The number and strength of sources of repayment reduces risk.
Bankers are by nature cautious lenders.
If they aren't that way naturally the banks credit committee and regulators will pounded into them loan
proposals and analysis that loan officers prepare literally list the primary secondary and tertiary
or third source of repayment.
For example the primary source of repayment for commercial real estate loan is the business's operations.
The secondary sources the sale of the building and the tertiary sources the guarantor other assets the
cross collateralized loan the debt service coverage ratio is a type of debt to income ratio that's used
for business loans.
It's calculated as income divided by debt payments.
The income number used is EBITDA which is earnings before interest tax depreciation and amortization.
Another way to think about it is net operational cash flow.
Less debt.
Cash outflows.
Lenders will calculate it based on the business's financials but will also compute the global debt service
coverage ratio who combines the business financials with the owners financials the global DSR gets back
to the concept of the last slide that the owners financial health can be a strength or a liability to
the company.
At the banks I worked at.
Lenders were looking for a ratio of one point to five or higher which is consistent with industry norms
a ratio of 1 means Ebola equals debt service the minimum ratio of one point to five adds a point to
five or 25 percent cushion.
Remember what I explained why Amr ization terms are longer than balloon terms.
Long amortization terms reduce periodic debt service payments which improves this ratio a borrower might
be well below a one point two five DSR with a 10 year Amitai ization term but well above it with a 25
year amortization terms.
In other words longer amortization allow more borrowers to qualify for larger business loans the debt
service coverage ratio measures your cash flow and ability to pay when lenders assess the risk of their
loan portfolio.
They break losses into two components the probability of default and the severity of default.
This ratio measures the probability of default which is how likely the borrow will be to not be able
to meet the contractual debt service obligations a second import ratio is the loan to value it's calculated
as the loan principal divided by the value of the collateral.
It's mostly used for real estate.
It may also be used for equipment.
Earlier I talked about how lenders may require an appraisal as part of the loan underwriting process.
The appraisal provides solid data for the denominator of this underwriting ratio.
Banks require owners to have equity in their business and assets partly to reduce the loss on liquidation
of the asset but also because owners take huge risks when they have nothing to lose.
For real estate lenders will limit the LTV of a loan to 75 to 80 percent which means the borrower will
make a 20 to 25 percent downpayment.
I talked about hard money lenders earlier.
They may limit LTV to 50 to 75 percent to reduce the high risk of their loans this ratio measures the
severity of loss which is also called the loss given default.
The previous ratio measured the probability of loss in this ratio measures how big the loss may be if
the borrower does default.
Loan covenants are ongoing requirements of the borrower during the life of the loan.
They are listed in the loan agreement.
They may include maintaining certain levels of debt ratios and other financial ratios like your current
ratio the available balance on a line of credit is determined by the borrowing base.
The borrowing base as a percentage of receivables or inventory whichever is collateralized in the line
that determines the available credit on the line.
This is measured and reported on a borrowing base certificate so both draws on lines and large decreases
in the borrowing base reduce the available credit on a line the loan agreement may require you to get
approval from the lender before you take on more debt.
The loan agreement or security agreement may require you to keep the collateral insured the lender may
require personal guarantees on business loans a guarantor is a person who pledges to pay back the loan.
If the borrower can't or won't pay it back the lender often has the right to require payment from a
guarantor even if the borrower hasn't defaulted.
For example the lender may be concerned about the future repayment ability and ability of the borrower.
So they approached the guarantor for payment sooner rather than later.
This is rare but they do have that right.
Lenders require personal guarantees from newer weaker companies personal guarantees are a big deal for
business owners.
If given the choice borrowers often choose lenders don't require personal guarantees.
Many owners set up their companies with business entity selections that limit personal liability like
LLC use or corporations.
They then try to get debt for the company and have to put their personal assets at risk to get that
debt.
It's a risk that's too much for some owners the bank will measure the financial strength of the guarantor
via financial ratios and the guarantors credit score.
I talked earlier about how using credit cards can burn owners later owners who trash their credit score
and personal credit cards won't be a strong enough guarantor for their company's business debt.
Another caution is that guarantors have joint and several liability.
Any guarantor can be required to repay the full amount of the loan.
Some collectors will collect on all guarantors and some will just pick the most likely guarantor to
pay and focus their collection efforts on that guarantor.
If you guarantee a loan and are much stronger financially than the other guarantors you may receive
more attention from the lenders collector who will let you work out a deal with the other guarantors
rather than the collector trying to broker a deal with everyone how common are personal guarantees.
Almost 60 percent of small businesses are required to provide a personal guarantee for their loans.
It's also interesting to note that half of small businesses use business assets for collateral while
almost a third pledge personal assets.