Commercial Lending is the process by which a bank, loan company or individual lends sums of money, in return for a rate of interest, to individuals or companies for the support of a business. The successful operation of the enterprise, as opposed to the securing collateral, represents the primary source of repayment of the interest and monies borrowed. The lender “underwrites” the loans or credits in order to measure the risk that the lender will not be repaid and to identify primary and secondary sources of repayment. Lenders always expect to fully collect the funds they advance and the interest and fees earned for the extension of credit.
Repayment of a loan can be amortized over a period of time using monthly, quarterly, semi-annual or annual payments with rates generally floating at some margin to the Prime Rate. Larger banks usually set their own Prime Rate while smaller banks will often utilize the Prime Rate as published by the Wall Street Journal. The usage of LIBOR (London Interbank Offered Rate) is becoming more prevalent in Commercial Lending borrowing scenarios.
The rate of interest is negotiated between the lender and the borrower. In addition to the interest charged on the loan, a lender may charge the borrower ancillary fees such as origination, application, credit reports, appraisals, underwriting and for other services in conjunction with making the loan.
Many banks will require a potential borrower to open a non-interest bearing deposit relationship which is commonly referred to as “compensating balances.”
Why Businesses Borrow?
Commercial loans are made to businesses to finance day-to-day activities and to finance other long/short term needs. Businesses may borrow to fund inventories, payroll requirements, supplier demands, new equipment, general expansion or the acquisition of plant and/or property. Many businesses are usually undercapitalized and the owners are often unable to contribute additional capital which creates the need to borrow.
Many companies simply have insufficient funds on hand to fund current operating or indirect expenses such as utilities, office staffing and those expenses often referred to as overhead. Often times, a business will have too little working capital and have day-to-day problems meeting current expenses simply because of a mismatch between the time expenses are incurred and the time that revenue is received.
Businesses borrow for many reasons. Some of the most common are:
- Leverage working capital and retained earnings
- Acquisition of real estate or other large fixed assets
- Future liquidity purposes
- Cover short term working capital shortfalls
- Insufficient working
Businesses generally have three types of borrowing needs:
1. Long Term Financing
Long term financing is often connected to the acquisition or financing of new or additional facilities or equipment. Maturity for these types of loans generally ranges anywhere from 5 to 20 years.
Commercial Company, Inc., requires a specialized machine to manufacture a new product line. Commercial Company has an ample customer base in which to fulfil orders which will cover the costs associated with the new equipment. Without the equipment, the company cannot efficiently manufacture the goods. Commercial Company, Inc., cannot afford to tap into cash reserves to directly purchase the equipment. Commercial Company,Inc., can effectively demonstrate the machines usefulness and the profit potential should it have the means to acquire the equipment through a long term amortizing loan.
2. Short Term Borrowing
Businesses often need to borrow because they experience timing differences between the time expenses are incurred and the time that the business collects for the goods or services they provided. Lines of credit are short term loans. A lender may commit to a LOC for up to 3 or 5 years.
Commercial Company, Inc., is an accounting firm and prepares an audit for a business, including tax returns. The process may take eight weeks or more to complete. The accounting firm must pay the salaries and travel expenses incurred during the audit. Typically, Commercial Company, Inc., collects a portion of the total estimated charges up-front or during the engagement; however, there are significant non-overhead expenses that the accounting firm must pay before it collects the remaining balance of their fees. Commercial Company, Inc., lacks sufficient internal working capital and therefore requires a line of credit to support the day-to-day operating shortfalls.
3. Working Capital Loans
Working capital loans are used to fund fixed operating costs that are not associated directly with goods or services sold, such as utilities and office operations. Working capital loans typically (term loans) have terms between 5 to 10 years.
Businesses will borrow when the business does not have sufficient retained earnings, cash flow or when the owners are unable to contribute additional capital.
Commercial Lending is available to absolutely every business imaginable. There are no biases relating to whom the borrower is providing goods or services to, in what quantity to borrow, what industry or geographic location. Unlike factoring or asset-based lending, Commercial Lending is the most unobtrusive form of financing available today. There’s only one catch! The qualifications to obtain a commercial loan product can be difficult.
All banks have similar underwriting standards as they operate within a heavily regulated and competitive industry. Almost 99 percent of banks are strictly cash flow lenders where they simply rely on the profits generated by the business to service the debt load. Many banks have collateral divisions in which they utilize an asset-based lending approach when structuring the loan.
For the purposes of this publication, broad stroke’s are required as banks all share a similar form of preliminary qualifications. Generally, those basic preliminary qualifications are:
- Time in business
- Management experience
- Credit of guarantors
Let’s examine each preliminary qualification in detail:
1. Time in business.
All banks consider the time a business has been in operation as a critical component in making a credit decision. Banks are looking to extend credit facilities to those business that have an established/proven track record. Businesses that have remained in business for a minium of three (3) years are normally considered to be established businesses.
A three year period provides a track record and allows an underwriter to consider and evaluate the historical business trends.
Start-ups or new business ventures are often difficult to finance unless they are well capitalized and the owners or management team has an exceptionally strong track record in the business. Along with time in business, a bank may also consider how long the current management team has been in place. A business with significant operating history that was recently acquired may receive additional scrutiny.
2. Management experience.
The importance of determining the ability of and likelihood that the owners/managers can and will operate the business successfully cannot be understated. When a bank lends money, they are essentially becoming a partner to the borrower business. Because they are a “silent” partner, they absolutely require the operator of the business to have excellent experience in the business. Management capacity generally will encompass a broad based understanding and a certain level of competence in all facets of the businesses operations, policy and administration. The result of a competent management team is the stability ,growth and profitable operation of the business.
3. Credit of guarantors.
Banks without question are “character” lenders in which the owners/officers personal credit is critical. With all lending relationships, character is of paramount importance. Personal habits have a significant correlation between a principal’s personal credit and the financial well being of the business. Banks do not lend to individuals who have weak personal credit.
All banks have their own unique appetite for borrowers and loan transactions. Industry preferences are a large portion of the menu for most banks. Many banks prefer to lend to businesses that provide goods as opposed to simply services.
Goods businesses produce a tangible product as opposed to a service business that simply provides a service. It is important to understand the industries in which you’re preferred lenders participate.
Another consideration is the state of the “industry.” A lender must evaluate the overall economic environment of the industry a borrower participates within. Depending on the state of the industry (depressed, stable, growth oriented, etc.), a lender must adjust their approach to lending.
Banks require an adequate amount of collateral to secure any loan. Many banks require a minimum collateral requirement above 1.5:1 percent. A borrower must have sufficient liquid or marketable collateral to satisfy a banks collateral requirement. Without collateral, there is no deal.
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