Have you ever wondered why one company gets an unsecured line of credit, another company’s credit facility is secured by all assets, and still others are declined entirely for commercial credit?
The equation is both complicated and simple at the same time. “What were the odds?” as my esteemed colleague, author and friend Larry Mandelberg would say.
Let’s start with simplicity. The simple version answers the mystery of commercial financing. The complex version speaks to the nuances between how various lenders, regulators, and risk managers see a credit request. I’ll deal with the complex version in another blog entry.
Basically, it is a risk – reward equation measured by leverage. It is not the lender’s prediction of whether or not you are going to fail. Consider the following:
- Banks typically earn 1-3% interest on their commercial loans after paying their overhead and cost of funds. If a borrower defaults on a loan, the bank must make 33-99 loans to earn back their lost principal. Banks need to make solid loans that contain minimal risk. They do this by looking first at leverage.
- Business owners inject equity into their business. They risk loosing all of their equity if the business fails. However their upside is that they reap profits that give them a potential very high rate of return. In some cases, business owners yield thousands of percent returns on their investment.
- Commercial finance companies will make loans when banks will not. These finance companies’ monitoring expenses might be ten times that of the banks’ expenses. This is because the banks generally do not make loans when heavy monitoring is needed (some do in specialty groups that mirror commercial finance companies). Money borrowed from finance companies is substantially more expensive than banks. If a default occurs, the finance company need only make 3-10 loans to make up the lost principal.
 In order to actually collect on accounts receivable in a default situation, the lender must know who is owed, have their contact information and preferably be in a position for the accounts to be sending their payments directly to the lender. Without heavy monitoring, it is not practical for a lender to gather this information at the last minute when a borrower is in default.
- Venture capital invests and takes ownership in the company. If the company succeeds, they may reap hundreds of percent returns on their investment. Venture capitalists are willing to take significantly more risk than other types of financiers. They may even lose money on 10 deals as long as they score big on one.
It all comes down to leverage and who has the most to lose. Leverage is easily discerned by the company’s debt to worth ratio. Different industries have different typical debt to worth ratios and are weighed unique to each industry’s norms.
From a general perspective a 1:1 debt to worth ratio means that the business owner’s equity equals the company’s debt. It also means that there are enough assets (at cost) to cover the debt. The equity provides a cushion for something that might go wrong in the future. Banks tend to have minimal conditions when lending to companies that have debt to worth ratios at or under 1:1.
Some companies are more leveraged. Perhaps their debt to worth ratio is closer to 1.5:1. These companies will typically be financed with secured lines of credit or secured term loans. As one approaches a 2:1 debt to worth, credit facilities become heavily conditioned and collateral is monitored to some extent. Some special industries may obtain financing at higher leverage ratios, but the ratios must be under the norm for that industry.
So there you have it. Leverage is the key determinate. Though do not get me wrong … there is a more complex version that all financers use to evaluate total risk and suitability for inclusion in their loan portfolio. Included are: debt service, competition, industry, payment history, outlook, assessment of management, age of business, etc.
Bob Stackhouse, President, Asset Commercial Credit © Bob Stackhouse – All rights reserved – October 2013
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