What Banks Look At First In A Commercial Loan Request (It’s Not Collateral)
Whether for a loan to fund a business need or a commercial real estate acquisition, cash (flow) is king and collateral takes a knee.
A bank’s underwriting of any commercial loan application is focused on the most likely and readily available sources of repayment of the loan, the risks to these sources, and their adequacy relative to the request. While there are exceptions, such as financing for construction of a spec home or equipment inventory flooring lines, a borrower’s preferred plan usually isn’t to sell their underlying collateral to repay a loan. Likewise, barring exceptions like those noted above, this isn’t the first source of repayment that banks analyze when reviewing a loan request.
Whatever is funded by a business loan should generate the cash that will pay the loan back. This is what bankers in the company of other bankers refer to as the “primary source of repayment.” If one is applying to buy an investment income property, the primary source of repayment is the cash flow derived from the rent of the property. This is cash net of any potential rents lost to vacancy, all expenses associated with the property, and distribution of any funds to ownership. Analysis includes comparable market rents and expenses, existing leases, and vacancy, etc. If cash flow derived from rental payments isn’t sufficient to pay back the loan plus a margin after all associated expenses have been paid, then it really doesn’t matter how low the loan amount is in comparison to the collateral value, credit is unlikely to be granted for such a request.
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One of the most common types of commercial loan requests where the planned source of repayment is neither cash flow nor liquidation of collateral is for a business line of credit meant to fund operating expenses pending the collection of receivables. In this instance, the primary source of repayment is collection of accounts receivable, which in turn retire the interim amounts borrowed on a credit line. Analysis includes the review of receivable collection times, dated outstanding balances, and concentrations within a prospective borrower’s clientele. Ultimately however, analysis of cash flow to pay the interest expense and/or the entire line of credit commitment over a period of time is also analyzed. At a minimum, the borrower should have cash flow sufficient to pay the interest on a credit line and any other term debt payments plus a margin. The more adequate cash flow is to retire an entire line of credit commitment if termed out and amortized over a short period of time (i.e. one, two, or five years), the stronger the application.
Similarly, when reviewing a request for equipment financing, a bank will analyze the cash flow of the business that will use the equipment. If cash flow, which is net of all business expenses and owners’ compensation before payment of debts, isn’t sufficient to pay back the loan plus a margin, how low the loan amount may be as compared to the collateral value likewise becomes irrelevant.
Collateral values can fall, whether by a softening real estate market, use and deterioration of equipment, or other economic factors that may erode the value of most any type of collateral. In the last recession, a number of borrowers in the United States found themselves in a position where they could not liquidate collateral and retire a debt in full without additional cash. While the Tri-Cities largely fared better than most, and continues to fare relatively well in the current downturn, this strongly positioned the planned primary source of repayment as the cornerstone of underwriting all commercial loan requests.
The starting point for underwriting the primary source of repayment is typically to evaluate historical cash flow. If prior years’ cash flow indicates capacity to repay the requested debt adequately, then what are the key risks and mitigating factors regarding the recurrence of cash flow at historical levels? Does the applicant show the ability over multiple years historically to repay the debt requested or must they replicate their best year every year for this to happen?
2020 was a year where some industries encountered reduced revenues due to a drop off in demand or other limitations. Many businesses continued to have strong revenues but experienced adverse impacts on profitability and resulting cash flow from supply chain and labor costs. Yet others had reduced revenues and improved margins, profitability, and cash flow from adjustments made to the new operating environment, while some experienced improved revenues and increased cash flow. While our hope is for fewer volatile years in the future, change is constant.
Banking industry consultant Jeff Judy often said, “Today’s loan is repaid from tomorrow’s cash flow.” While we begin with the context of the prior years’ performance, we also are looking for indicators of what cash flow will be later this year, next year, and for the life of the loan. Ultimately, banks are reviewing the same factors that impact returns to business owners and real estate investors. A discussion about the cash flow planned to pay back a requested loan is a good place to start the conversation regarding any new commercial loan application.
In my prior article in November 2020, I discussed secondary capacity – a borrower’s fallback position between cash flow and liquidation of collateral. My next article will focus on collateral, which is most often the last planned source of repayment reviewed in commercial loan application analysis.
Amanda Jones, NMLS #1709212
Commercial Lender, Community First Bank
