Banker Speak and Perspectives 101
The minds of a Banker and an Entrepreneur are like the hunter and the farmer. Both are providers and important to the community’s survival but their personalities are fundamentally different. What follows is a brief framework for an Entrepreneur’s understanding of a Banker’s perspective. Note: in this article the terms Entrepreneur, Owner, and Borrower are used synonymously.
When a Banker first gets a loan request their first thoughts are: What bad things could happen which would result in not being repaid? What will prevent these bad things from happening, and what alarms (covenants) can I put into the loan to alert me if bad things start happening? Put into Banker speak, what are the key risks and how do I mitigate?
From a return on assets perspective; Bankers need to be pessimistic. Banks are making < 2% annual return on the money they lend so they have to be right (not lose money) 99% of the time (Richard Kovacevich). Banks need close to a sure thing 99% of the time and therefore need to be extremely more conservative than say an Entrepreneur who is making > 10% return and can therefore take on more risk.
Philosophically, Bankers must be very conservative because they are protecting everyone’s money who has entrusted it to the bank (Grandparents, grade school teachers, etc.). Note: Good bankers look at every deal as if they are lending their Grandmother’s money. Therefore they need to be methodical and have good judgment.
Below are the four guiding principles a Banker follows with brief explanations.
The 4 C’s of lending:
Credit: borrowing history with similar debt repayment (business credit rating).
-Debt Service Coverage Ratio ≥ 1.25X
-For every $1 of loan payment there needs to be ≥ $1.25 in cash flow (EBITDA).
-Look-back over 3 years of financials to compare historic ability. -Leverage ≤ 3X is important. This includes the requested debt.
Capital: aka Collateral
-What is the equity position of the company?
-No bank will lend more than there is in equity.-If equity is insufficient, then what is needed is an equity injection not a loan.
-What is the quality of the proposed loan collateral?
-What is it worth at a fire sale?-Not considered collateral: Good Will, work-in-progress, tenant improvements
-What is the cash position of the company? Cash is king.
-Judgment of Borrower by the Banker.
-Ease of working with the business owner.-Owner’s understanding of their business and financials.-General “vibe” the borrower gives the Banker.
-Owner’s personal history.
-FICO (History of meeting debt obligations).-Any litigation or criminal background.
-Does the owner take all the profits out of the business every year and is now asking a bank to make up the difference?
Financial analysis will answer 1-3. The art to lending is in #4. Ultimately lending boils down to a judgment call by the Banker. Entrepreneurs who address the 4 C’s up front and use it as a framework for their borrowing requests have significantly better borrowing outcomes.