Gary Schafer

The Changed Landscape

Prior to mid-2008, investment banks and, in some cases, venture capital financing provided a significant amount of high-end commercial credit. The financial collapse drove many of these groups out of the lending market. In addition, many commercial banks face restrictions on their lending. Commercial banks with capital available to lend can now select from among the largest and highest-rated companies that may have borrowed elsewhere in the past.

Middle-market companies should be prepared for higher interest margins, tighter credit monitoring and lower loan-to-value ratios. And based upon recent industry surveys and the word on the street from commercial lenders, this situation won’t change any time soon.

Back to Basics

So the credit vise remains tight for the near term—that’s not a surprise. Commercial lenders say the industry is “going back to the basics” in its approach to lending. As a borrower, you can take some basic steps of your own to prepare.

• Build relationships and demonstrate personal integrity. It’s true in many situations and especially when dealing with lenders:  If a banker can look a business owner in the eye and be comfortable the borrower will do whatever is necessary to repay a loan, the bank is more likely to go out of its way to work with that person. Other things lenders say they look for:
• Business leaders who are seen as upstanding, reliable and engaged community members
• Companies interested in building long-term, mutually beneficial relationships, rather than just “price shopping”
• Communicate well and often. Nobody likes unpleasant surprises; bankers especially hate them. Lenders say many credit problems could be avoided (or at least moderated) by more timely, substantive communication beyond faxing over a quarterly income statement.
• Talk with your business advisors (your lender, but also your CPA, lawyer, insurance broker, etc.) about significant issues facing your business—both opportunities and challenges.
• If you have good news, share it. But never sit on bad news. Communicating potential trouble early can help you bring more resources to bear to address the problem while there’s still time to fix it.
• Report your financials with authority. Bring balance sheets that balance. Provide timely and complete operating statements. Set accurate and attainable budgets. Explain key trends and significant changes. Avoid recurring prior period corrections, busts in inventory cut-off, etc. Consistent reporting a lender can have confidence in will make a big difference when you start showing a trend of growing sales and improving margins—and want to ask for more capacity on your line of credit.
• Buff up your equity section. Owners’ equity on your balance sheet represents a “collateral value” to borrow against. Losses in recent years have depleted retained earnings. Owners continuing to take distributions or dividends (perhaps to compensate for losses in other ventures or the stock market) have amplified this problem. Some action steps you could take to increase owners’ equity include:
• Reduce dividends and distributions to the bare minimum necessary.
• Increase profitability. While this may sound obvious, some business owners are focused on minimizing tax liabilities by keeping reported earnings low. This can be at odds with improving creditworthiness.
• Infuse additional equity capital. This can be done by existing owners contributing additional cash or assets, converting shareholder debt to equity or finding an additional equity investor. Other considerations, such as estate planning or risk management, also must be evaluated.
• Find hidden equity. If any of the company’s personal property or real estate available as collateral can be appraised for more than the financial statement carrying value, that can be established to provide you with additional borrowing capacity.
• Leverage = Risk. The more debt a company carries compared to its assets and equity, the more risk it presents to a lender. Reducing the balance of your existing debt may give you flexibility to refinance on better terms or to develop a new lending relationship. Many of the steps described above for improving owners’ equity also can help you reduce your debt load.
• Cash flow is king. Having a strong balance sheet or showing profits is important, but at the end of the day what a lender really wants to know is whether your business will generate the cash needed to repay the loan. Fixed charges are recurring expenses required for you to operate your business, including rent and lease expenses plus debt service. Lenders want to know you can cover these costs through the cash flows your business generates—consistently. How can you improve here?
• Manage fixed charges. These costs can be some of the most difficult to control, but reducing them can improve your cash flow and your borrowing capacity. Tactics may include renegotiating significant leases or adjusting repayment terms of debt to related parties, vendors or other lenders.
• Eliminate cash flow drains. Anything that drags down your profitability likely also siphons your cash. Eliminating unprofitable product lines, limiting overtime or selling excess inventory and unused equipment to pay down debt can help to improve your cash flow.
• Leave wiggle room. Be prepared for lenders to ask for more stringent financial ratios, increased collateral monitoring and (grumble) personal guarantees. And be ready for things not to go as planned; leave some margin for error in projections and have contingency plans in place. That way, coming in “just short” won’t leave you high and dry. Smaller borrowers may especially struggle with this, as there is less room for “fudge factor” when your numbers are smaller.

“The best way to qualify for a loan is not to need one.” That is perhaps truer today than it ever has been. Achieving meaningful changes to the metrics lenders are watching will require careful planning, commitment from management and owners and significant financial discipline. Your BKD advisors stand ready to work alongside you through the unique challenges you face.

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Thanks to the commercial lenders and borrowers who contributed to this article. Special thanks go to Michael Garner and Brent Kembell with UMB Bank and Timothy Oetting with US Bank for their time and input.