How Banks Evaluate Loan Requests

In putting together the best possible package to secure a business loan, it's important to know what happens after you leave the bank and the lending officer evaluates your request.

First, a word of warning from Roger Bel Air, author of How to Borrow Money from a Banker and national lecturer: Banks are in business to lend money and get it repaid - with interest. That's their number one priority. Several key factors are contributing to heightened cautiousness on their part, including concern about a greater number of business failures and losses in the face of an economic recession and tougher loan examination policies by federal bank regulators as a result of the savings and loan crisis.

"A banker's career is based on not making mistakes," Bel Air stresses. "And determining whether or not the bank will be repaid - the bottom line in any loan decision - is subjective. Beyond the facts and figures alone, banks want to see that the applicant has thoroughly reviewed his options, laid the necessary groundwork for borrowing, and prepared a clearly-written and well-organized loan application. This is particularly true in today's credit-tight market as lending officers feel a tightening of the screws from regulators, and uncertainty about the future."

Another advantage of preparing an effectively organized loan application (including the all-important business plan) is that it will significantly decrease the time spent waiting for an answer. According to John Nelson III, SCORE counselor in Rhode Island and vice president of a major U.S. bank, "in about 80 percent of the cases, the formal request is not complete." Much of the time spent in approving a loan can be traced to the banker having to ask the potential borrower for more information or for clarification of the information that has already been submitted.

In evaluating loan applications, the three Cs of credit are taken into account - character, capacity, and collateral.

1. Character
   Character is actually a check on your financial status and personal credit history, including your previous loan payment record. The theory is that people are creatures of habit - if you have repaid a loan on time before, you will repay this one as well. Conversely, if you have defaulted on a previous loan, the danger is that you'll tend to default again.
   
   Also considered is experience in the type of business you are trying to finance, including level of responsibility, education, and business management training. Lenders are particularly concerned that potential borrowers have a solid understanding of financial record keeping, business credit, the importance of collecting accounts receivable, inventory control and turnover, and marketing their product or service.
   
   If your prior business experience is not relevant to your current venture (for example, if your career has been in the corporate world, and you want to start a restaurant), banks will be leery about your ability to run the new endeavor successfully and thus repay the loan.
   
2. Capacity
   Prudent bankers have always looked first to the cash flow of the business as the way the loan will be repaid, which underlines the importance of preparing a cash flow statement with future cash flow projections before presenting your loan request. Doing so indicates to the lender that you are knowledgeable about the cash coming into your business, and are therefore better able to avoid a cash shortage that would jeopardize making monthly payments.
   
3. Collateral
   While cash flow is the primary source of loan repayment, lenders will want a backup or secondary source as an exit or last resort, should your business not prove profitable. Collateral - defined as "anything of value used as security for repayment of a debt or performance of a contract" - can be real estate, stocks and bonds, savings account passbooks, equipment, accounts receivable, or the cash value of life insurance policies.

Psychologically, lenders feel that borrowers have more interest in repaying the loan if they know that failure to do so will result in the lender taking possession of whatever has been put up for collateral. A lender will also try to obtain personal guarantees so that if you default on the loan, the institution has access to your personal assets.

It's important to note that these days, in the wake of severe economic downturns such as that experienced in the Southwest in the mid-1980s, collateral doesn't carry the weight it used to. As the president of an Oklahoma bank stated, "In Oklahoma City, you can buy a building today for what it cost to rent one eight or nine years ago." So banks are likely to require more collateral than was previously the case, and evaluate it based on market - rather than replacement - value. Companies without enough collateral to pledge will have to scale back their borrowing needs and make do with less.

One final tip is not to forget "relationship banking." Once a relationship has been established and you've explained your business operations and anticipated needs, it becomes far easier to approach a banker when a loan is needed. This familiarity will make you more credible than a customer who has not taken the time to introduce himself.

Be sure to stay close to your banker; be open and honest about major changes and significant events, whether good or bad.. As your lending officer has to tell your story to other people in the organization (including his superiors), nothing can jinx the relationship faster than a lack of candor. Feeding bankers regular information is, of course, time-consuming when you have a company to run. However, it's all part of building credibility and trust, and will enable you to use your banker's knowledge to help ensure the continued success of your business.

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