Commercial loan underwriting: The criteria for lending

corruptionBusinesses must have access to capital for many reasons, including common requirements such as:

  • Start-up of a business
  • Growth and expansion
  • Major asset acquisitions
  • On-going working capital

I have had the privilege of working with the U.S. Small Business Administration as part of their loan approval process for SBA 504 loans for the past 30 years.  This experience has provided me with insight as to how loans are underwritten and approved.  I have worked with a lot of very talented senior bankers and other financial experts – and learned from them.

A bank or other lender will generally want to analyze the finances of a business along with the reasons for the requested borrowing.  This process is commonly known as Commercial Loan Underwriting.  A business owner should understand the essential basics of this process to determine if the business has a reasonable expectation to successfully repay borrowed money.  This understanding will also help facilitate the lending process and make it easier and more efficient for both the borrower and lender.

Commercial loan underwriting is a structured process.  This process includes are three broad categories of required information and analysis:

1.General background data

  • The underwriters will want to know the credit history of the business and its principal owners. What are the credit scores and have there been prior defaults?  Has the lender made loans previously to this borrower?
  • What is the money to be used for? Are there valid business reasons for the loan and how will it impact the business?
  • What is the business history, and how is the industry expected to perform in the future?
  • Are there business projections for the future? Are these projections competently prepared and are they realistic?
  • Are there contingencies or other possible sources of liabilities? The creditability and thoroughness of the financial presentations are very important to an underwriter.

2. Repayment ability

  • Lenders are in business to sell money for a profit. Is there a realistic possibility of timely repayment?  The history of the business and the projections for the future will be used by the underwriter for this analysis.
  • A primary tool used by lenders is financial ratio analysis. One of the most important lending ratios is known as a “Coverage Ratio”.  This is comparing the expected profits/cash flow of the business to the on-going loan payments that will be required to repay the loan.   For example:  If the monthly profits are projected to be $15,000/month and the loan payment is $10,000/month the coverage ratio is $15,000/$10,000 or 1.5 to 1.  Most lenders commonly require ratios of at least 1.25/1.
  • Other ratios are also important to underwriting. The amount of business debt versus business equity is known as the “Debt/equity ratio”.  The more debt that a business has in relation to its equity (the “leverage ratio”) the weaker the financial position.  A business that is highly leveraged cannot absorb temporary setbacks unless the owners have independent sources of money to contribute.
  • The ratio of inventory held by a business to the amount of products it sells will indicate the “turnover” rate – how rapidly the inventory is bought and sold.  An inventory with a slow turnover may be an indication that the inventory is obsolete or that the company is not well-managed.   Auto manufacturers for example will stop producing cars if the unsold inventory exceeds a certain threshold.  For example if unsold inventory is over 60 days, auto manufacturers stop producing cars and start laying off production workers.

3. Security, other assets if there is a default

  • Lenders will look for adequate assets to use as security in the case of a loan default. The lenders will look to the business assets generated by the loan or other business assets.  The security can also be personal guarantees of the owners or other external assets that might be owned such as real estate, stocks and securities or other business interests.
  • A loan, or loans, secured by multiple assets or involving multiple businesses are “cross-collateralized” loans.

Bankers and other lenders will analyze loans in terms of risk.  Riskier loans generally will cause lenders to require more security, ask for higher down payments, charge higher interest rates, and/or shorten the loan repayment period.  A potential borrower must be aware of underwriting criteria so that they can have a reasonable prospect of successfully borrowing money.