Primer on Banks
Introduction to Commercial Banking
Common Terms Used in the Banking Industry
The banking industry, like most professions, has its own ``lingo", and if you are going to have to ask a bank for money, it is better that you know some of the more common terms associated with bank loans.
Bank Loan Instruments
A bank instrument is simply the document or contract evidencing a debt. In other words, a bank instrument is the contract you sign when you get your loan from the bank. Examples of bank instruments used when small businesses are being financed include:
- Demand Note: This is a promissory note from a company to a bank. A demand note may or may not identify specific due date for the loan, but it will always have to be paid back on demand by the bank. This means that whenever the bank decides that it wants its money, it simply says so and you will have to pay up ... or else. (See Bankruptcy section)
- Letter of Credit (L/C): This document is used when the bank grants the holder an amount of credit equal to the face amount of the letter of credit. (Notice that you hold onto this document.) These documents are used as guarantees that even if the company cannot pay for services or products bought on credit, a bank will. These letters are also often used in overseas transactions.
- Revolving Loan: These are short-term loans typically secured by a company's account receivables and inventory. The money received from paid accounts receivables and sold inventory is then used to pay off the revolving debt. Of course, the next round of orders for services and products purchased by your company usually draws on this revolving loan so the balance goes back up, and the process starts over again. Now you can see why it is called a revolving loan.
- Term Loan: These are loans that usually last for over one year. Revolving loans are often refinanced into terms loans. These loans resemble the car loans and student loans you may be familiar with. Monthly or quarterly payments have to be made by the company and the interest rate will be a little higher than a revolving loan. These loans are almost always secured, typically by assets of the company (and often its owners too).
- Liquid Assets: These are assets that can be easily sold or taken by a bank or creditor in the event a loan goes into default. Examples of liquid assets are: current account receivables, finished goods inventory, cash, tradable securities.
- Hard Assets: These are assets that are not as easily sold but are still valuable. Examples include: machinery, equipment, buildings, land, automobiles, furniture, etc. These assets usually depreciate in value over time, thus banks will typically require that a loan secured by hard assets be over-secured (i.e., the assets' value exceeds the amount of the loan).
- Guarantees: These are third-party promises to pay the loan if the company cannot. Company owners and their spouses, relatives, friends and other parties having a connection to the company are often asked to personally guarantee a loan. Also, if the company is owned by a person who owns another business, the other business may be asked to sign as a guarantor.
- Prime Rate: Prime Rate is the rate of interest a bank charges their very best commercial loan customers. This rate is basically set by large banks in large cities. Banks all across the country then follow suit. (For those of you who care about such things, the Federal Reserve Bank does not set this rate, although its actions do affect the Prime Rate.)
- Basis Points: This is a fancy way of referring to the interest percentage rate. One hundred basis points equals one percentage point of interest (e.g., 100 basis points equals 1%, 250 basis points equals 2.5%).
Accounting and Business Terms
- Working Capital: This is simply the dollar value of a company's current assets minus the company's current liabilities (e.g., loans, unpaid purchase orders, etc.) A working capital loan helps create the sales necessary to generate account receivables and inventory (assets!).
- Debt to Equity: This is a ratio used to measure how ``safe" it is for a bank to loan to a company (something which, in reality, is impossible to measure). The higher the debt to equity ration, the less likely a bank is to approve a loan. Small companies should be in the 3:1 range. That means there should be one dollar of company worth for every three dollars of debt owed by the company. So if the business is worth $100,000, a debt load of $300,000 is about as high as it should go. (This is only a rule of thumb, of course, if a small company shows enormous potential, this measure goes out the window. And if the small business is in a dying industry, no one will want to loan it money, regardless of this ratio.)
How Bankers See the World
Bankers are business people too; they are seeking profit, just like you. With that in mind, you should realize that when asked for a loan, bankers perform same kind of analysis that you perform when you are presented with a business opportunity: How much money can I make off of the opportunity? How likely is it that the opportunity will pan out, and what are the chances of failure? Do I trust the people I'm getting involved with? Etc.
The difference between you and the bankers, however, is that you probably do not have a large, imposing building on main street and a lot of obfuscating terminology describing simple concepts. (Bankers are a lot like lawyers in that way.) But behind all of the terminology, there is a relatively short list of things bankers require in a business when they are going to make a loan.
1. A relatively close relationship between the borrower and the bank. This is first and foremost to most bankers that you will deal with. Bankers want to know who it is exactly that they are loaning money to, they want to know who to call when problems arise, and who to stay in touch with to find out how things are going. Obviously, bankers never give money to strangers, so get to know them personally through lunches and frequent contact.
Also, build up a history of sound financial management with the banker. Take out a small loan for a vacation or car when you do not need money for it, then pay back the loan very quickly. After you start your business, do the same thing with a small loan. You should also be quick to offer balance sheets and other financial records to the banker. Apart from demonstrating that you know how to keep financial records, it will show that you have nothing to hide. Another smaller action you can do is always pay attention to your checking balances and never overdraw it.
2. Managerial ability of the owner. Just as a bankers want to know the person who is borrowing the money, the bankers must make sure that the people who are getting the money are capable of handling the money and putting it to work properly. To put it another way, the last thing in the world that bankers want to do (besides lose money) is foreclose on a loan and take the collateral. So they make loans to businesses they think will survive.
Bankers will often spend some time investigating your background and experience to determine whether you have business acumen. Past employers, suppliers, customers, and other business associates are often contacted as part of this investigation. Hopefully, you did not burn bridges in the past.
3. References from other businesses and banks. Bankers want to know that other people, especially other bankers, are willing to vouch for your honesty and reputation. But bankers also get concerned when you are moving from one bank to another. People generally stay with the bankers they already know, so if you are changing banks, there had better be a good reason (and personality conflicts or refusal to offer a loan is not a good reason as far as a banker is concerned).
4. Credit history of owner and business. In both cases, the credit history had better be fairly clean. Bankers do not loan money to former bankrupts, regardless of how good their current business may be. And if you have defaulted on a loan or credit card in the past, forget it.
5. Collateral offered as security for the loan. Collateral calms the minds of bankers making loans the way homeowner's insurance offers you or your parents peace of mind: if the worst should happen, it will not be as bad as it could have been without it. As a result, bankers go without collateral on a loan about as often as a sane homeowner goes without insurance: never. Collateral usually determines how much loan money you will get. (Bankers are typically willing to loan a business about 80% of the face value of accounts receivables and 20-40% of the value of inventory. Hard assets can garner you about 60-80% of their fire-sale resale value.)
6. Amount of money put into the business by the owner. Bankers are more comfortable loaning to a businessperson who invests significant amounts of their own money in their business, and many bankers require it before they will give a loan. This sort of investment assures the bankers that owners are committed to the business and will do whatever it takes to keep it healthy. After all, if you will not put your own money into it, why should anyone else?
7. Ability to repay the loan with cash from the business. Simply put, the company needs to be bringing in enough money to repay the loan. Collateral and personal guarantees are seen as backstops against a loss due to loan default, they are not seen as substitutes for a source of revenue to repay the loan--the company has to be able to do that. Banks will ask you for projections of your business's future cash flow. This projected cash flow will then be compared against the expenses and outstanding financial obligations of the business. If there is enough money ``left over" to make loan payments, you will get a loan. But be aware that your cash flow projections are going to be discounted by the bank to a lesser number. So if you claim cash flow of $10,000 a month, the bank may give it a value of between $6,000 to $8,000. Banks like to build in a margin of ``cushion" for any temporary downturns.
8. Larger economic trends. This is the ``finger-in-the-wind" analysis of bankers. The look at your business and compare this against what they know about the state of the economy and industry trends. Obviously, during bad economic times bankers will be much less willing to make loans. And if your industry is commonly regarded as one which is dying out, forget it.