Lenders not only provide funds to ‘healthy’ companies

It is a misconception that lenders only give money to healthy and viable companies

Let’s start with the need! Why do firms borrow money? If you think about it there are actually two separate questions. The first question is why does the firm need money – as in what will the money be used for? The second question is why is the firm borrowing money? A healthy business should  have a number of financing options readily available – why is a bank loan the first choice? Is it the first choice of lenders?

How these questions are asked and answered is a key input in the final credit decision by lenders.

Why does the firm need money and what is it going to do with it? The most common reasons shared by loan applicant are:

1. To fund working capital. Businesses need to invest in inventories & receivables before they can generate and collect revenues from customers. A working capital loan is used to fund inventories and current assets build up and is paid off when these assets are converted into sales or cash. Firms use the working capital loans to cover operating expenses during the production and sales cycles and then use proceeds from the collection cycle to pay down the loan.
2. To get better terms on existing loans or lines of credit. Although businesses prefer to work with relationships, any exercise that can improve fixed cost structure of a firm can create value. The fact is interest payments are as fixed as it gets (despite their occasional floating nature) and it is difficult to ignore proposals that can reduce debt servicing load on operating income. Improving credit conditions and scores, lower market interest rates, competition, economic growth are all factors which should result in a higher credit ranking and lower interest rates for a customer.
3. Growth. Return on equity and retention ratios determine the rate at which a business can grow without resorting to external funding. When businesses grow faster than their sustainable growth rate, they need external sources to fund the excess growth. The real issue with growth is that it needs to be managed. More businesses fail due to mismanaged and out of control growth than due to an absence of the same. In a credit setting it’s wise to remember that growth is the most common reason for business loans as well as business bankruptcies.
4. Expansion of business. Beyond organic growth covered above, businesses also come across opportunities to expand in jumps. Investment in new plant and equipment, land, real estate, warehouses is one way to do it. Buying related businesses or franchises, new branches and locations are others. These are normally classified as special projects. A key consideration is the value created by the project by itself as well as part of the business.

Some businesses are reluctant to disclose the exact motivation behind borrowing. In such instances stage of development of a firm can justify, to some extent, the rationale behind the loan. However, for the credit analysis process to work and for the optimal design of the credit facility it is important that the exact need and use of proceeds is identified.

Sources of repayment.

Once the need and use are identified, the next big question lenders have is how the loan will be paid back?

Some potential repayment sources lenders look at are:

1. Healthy companies generate positive cash flows from operations, with which they can make interest payments and repay principal. If a loan will accrue value by increasing cash flows and improving profitability then the incremental change in cash flows and profitability will become the source for repayment. A new plant that adds capacity in a growing market where customers orders are backlogged is one example.
2. Companies also sell or convert liquid assets to generate cash. The generated cash is dependent on how and when cash conversion or sale occurs. Current assets, like inventory and customer receivables, when converted to cash under the normal operating cycle, generate excess cash captured in the form of profits. However the same asset when liquidated under bankruptcy may not cover costs. The same holds true for receivables when factored or sold under times of stress. Some businesses also hold excess cash or cash reserve on their balance sheets.
3. Fixed assets are a tricky item. If the two sources above cannot cover the loan you are in “big game territory” or asset based lending. The question that you may want to ask yourself is – With the possible exception of real estate, how do you plan to collect on the loan in event of default? You need to walk through the worst-case scenarios first to see if the end result would be acceptable to the bank. Remember the bank is primarily in the lending business. While foreclosures and forced sales are part of the workout business, they destroy value for both the bank and the client. Even if a lender has a direct claim on the title for the asset, bankruptcies and workouts get complex very quickly. Especially if a court decides that the asset in question is essential for allowing the business to survive as a going concern.
4. It is also very common for a firm to take on fresh debt to refinance maturing loans. Such a situation is generally applicable to companies that maintain a specific level of debt or leverage. When the time to repay maturing loans comes, instead of using cash flows from operations, these companies take on new debt to pay off maturing obligations.
5. As businesses become profitable, attract additional equity investment or start building up cash reserves it is quite common for them to pay off existing loans to improve profitability and cash positions.

Most lenders want to identify at least two reliable and independent sources of repayment. One primary, one secondary.