In previous articles, I talked about the types of finance that a business can structure to meet the needs of the Business whether it be to buy a long-term asset or to fund the working capital.
Whether you are borrowing from a mainstream Bank or a Secondary lender the approach to the request is much the same and it is key to remember that what you provide to a Lender in terms of information must be key information that you use to manage your business on a day to day, week to week, month to month basis. We often talk about the provision of “Management Information “that a lender will want to see on a regular basis.
The key here though is that it is “Information” that you use to “Manage “your business. So first and foremost, the information must be fit for purpose including KPI’s (Key Performance Indicators) that you need to know to make sound decisions on the trajectory of your business.
Having also been on both sides of the fence, it is important to remember a mutual respect for each other’s position. The Lender is assuming the lending risk and will ask lots of questions while the business carries the risk/challenge of making money and repaying the Lender.
The Philosophy for Lending
When a Bank lends it does so because they judge that they will get their money back on an agreed future date. To reach their decision, they must make a prediction of the future and as they do not have the benefit of a crystal ball, they cannot do this with absolute certainty.
The aim of their lending appraisal process is to assess and eliminate uncertainties. This involves assembling all the information they need and then evaluating it correctly. There is no definitive analytical process through which they can make their assessment, and this is why many experienced lenders describe lending as an “art” rather than a “science”. That said as technology has evolved there are several “platform” lenders that will just process information and the computer says yes or no. This is normally for low amounts, very quick and very expensive.
Let us stick with the theme that you are approaching a Lender for a sensible amount of funds at a sensible price. On that basis let me set out the methodical approach that each lender should take or a close variation on a theme.
Of equal importance to the approach is the state of mind in which the lender approaches the assessment. There is an overriding need to form an objective view. This means not being influenced by outside pressures or preconceptions. To be seen as professional lenders, they will not take a decision too quickly or based on inadequate information. Equally, if the ultimate decision is going to be No then they have a duty to tell you quickly and with explanation.
With that in mind let us just run through some Do’s and Don’ts from the Lender’s perspective:
DO ask for time to consider the proposition and give a sensible timeframe. They will always try to seek financial information before a meeting so that it can be assessed, and questions identified.
DON’T make assumptions or fill the gaps themselves – it is their responsibility to get full information from the Business.
DON’T accept the Business statements at face value. Do not be offended by this as they will seek evidence that will provide independent corroboration.
DO distinguish between facts, estimates and opinions when forming their judgement – these elements will carry different weights in the final evaluation.
DO be sure that they understand the risk involved in the proposition before reaching a decision. If they cannot understand the request, they will not do it.
Methodical Approach to Appraisal
Once a lender has met you, asked the questions and assimilated the financial information they will then begin their review of the application and write their internal “credit” paper for decision.
It is at this stage that the “Canons of Good Lending” are applied. There are many a mnemonic used in different Banks/Lenders but one of the oldest and still used today is CAMPARI:
Character: This is perhaps the most difficult area for a lender to assess but one of crucial importance. It is impossible to judge somebody’s character based on a few meetings and this area will be assessed on facts and evidence. The sort of questions they will ask themselves:
- Can his/her word be trusted as regards the details of the proposition and the promise of repayment?
- Is his/her approach conservative or does he/she tend towards the over-optimistic?
- What is his/her track record?
- If a new client to the lender, why have they come to them?
Ability: This covers the extent to which a client is successful in managing his/her Business and financial affairs:
- Does the management have the necessary production, marketing, and finance skills?
- What qualifications do they have – ISO?
- What is their motivation and capacity to succeed?
- What is their experience in the field for which the finance is required? How well do they know their sector and competitors? Spread of clients?
Margin: The Lender is in business to make profits and give shareholders a fair return on their investment.
The interest margin, commission and fees should be agreed with you at the outset.
The interest margin will reflect the risk they perceive in the advance and in today’s market they have sophisticated pricing models based on sector, amount, term, and security.
Purpose: Is the lender willing to lend for the purpose given and can it be verified. In this highly regulated world, there are sectors that a lender will not get involved in and they will qualify themselves out right from the beginning. Trade with UN sanctioned countries will be prohibited.
Amount: There are dangers for a lender to lend either too much or too little. They will establish that the amount required is correct and ensure all incidental expenses have been considered.
You as the borrower should ask for sufficient to cover contingencies.
Is the amount requested in proportion to the Borrower’s own resources and contribution? Normally, a reasonable contribution from the borrower to show evidence of commitment and the borrower’s stake provides a buffer should problems occur.
Repayment: Source of repayment must be clear from the outset, and they will establish with a degree of certainty that the promised funds will be received. It is here that the real risk of lending is assessed.
If the lending is for working capital, then the lender will satisfy themselves as to the revolving nature of the cash and current assets/liabilities.
If the lending is a term commitment and clearance is to come from income/cashflow, then they will undertake a full appraisal of the forward projections with one eye on the historical performance to demonstrate the achievability of forecasts, the assumptions made and the ability to cover all funding costs, not just the new lending. In some instances where the lending is “forecast led” and by that, I mean an over reliance on future performance is required then the lender may require Independent Financial Due Diligence. This is not a bad thing and whilst it will cost, it is undertaken by a well-known firm of accountants (ideally with good knowledge of your sector) who will provide the lender with independent assurance of the forecasts and sensitivities to those forecasts.
It is at this stage that financial covenants will be considered in terms of annual debt service by profits and cash generation. When entering a term commitment of, say, 10 years a lender will have triggers to monitor performance both against the Management Information provided and annual audited accounts. If any of the triggers are” breached” then the facility becomes repayable on demand. There is then a period of remediation where the borrower can satisfy the breach or if not, then the facility is renegotiated or repaid if that is an option.
Insurance (Security): All the above “Canons of Lending” need to be satisfied irrespective of any security available, but a lender will always consider whether security is necessary in case the repayment plans do not work out.
The lender will make sure that the security is freely available to be given taking all parties involved into account. There have been many legal precedents over the years that impact this decision.
Additionally, tangible security for a lending will have a marginal impact on the interest margin for the better.
The lender will always ensure that their security is perfected and in place before any money is released.
Monitoring and Control
Once the lender has made their decision and agreed to lend the money, it is unrealistic of them to expect a customer’s plans to work out perfectly and will therefore need to carry out regular reviews of progress in addition to checking for covenant compliance as detailed above.
The regular reviews will normally be monthly, and it should be a two-way street. The lender will want to monitor trading performance to budget but it is also the opportunity for the customer to keep the lender up to date with current trading conditions and future expectations. A monthly suite of Management Information should consist of:
- Monthly Profit & Loss, Balance Sheet and Cashflow.
- Commentary to the Profit & Loss. Do not repeat the numbers but, rather give good insight into why the numbers are what they are.
- Revised Annual Forecast. By that I mean taking the original budget and inserting actual performance as the months pass. So, for instance, at the halfway stage, the forecast will consist of 6 months actual trading and 6 month’s forecasts. NOTE: keep the original budget intact as the revised annual forecast will dictate future action whether that be cost cutting or funding further growth.
With this information supported by a discussion, the lender will be able to continually assess the risk and support the business better.
I hope that this gives some insight to a lender’s approach to a borrowing request and importantly, support your thinking around the type of process and the information you will need to produce and keep up to date in a timely manner. Problems occur when there is a lack of communication.
About the Author
Ian Taylor is a highly experienced Business Advisor and Financial Services Professional, with more than thirty years’ expertise in Senior Executive roles with Barclays and BNP Paribas: building successful and award winning teams, developing robust, long term client relationships, and leading a series of complex market related projects to support clients to grow.
Amongst extensive professional training, highlights include successfully completing the Larger Corporate Business Programme at Henley Management College as well as the prestigious Insead CEDEP General Management Programme. Ian is an Associate of the Chartered Institute of Bankers.