How Bankers Assesses Small Business loan Applications

Small business loan application is one of the common requests with high rejection rate in the commercial banking system.Who should be blamed for these loan rejections? Entrepreneurs, bankers or government regulators? I mostly blame the entrepreneurs for lack of preparation. In this article, I have discussed some key areas bankers consider when they are assessing small business loan applications.

You would agree with me that bankers are in the business of making money mainly through risk management and intermediary function. They accept deposit from those who want to save and give part of it as a loan to borrowers. They are expected to protect the depositors’ money as well as the shareholders’ investment. Regulators such as Central bank are continually checking the risk exposures and liquidity management in the banks.

Therefore, banks have to develop a framework that will expose a potentially bad loan from the good loans at the application stage. This approach can sometimes be complex models or a simple checklist. Generally, banks use 6 key areas to assess small business loan applications.

6 Conditions of Small Business Loan Application

1. Character of the business owner

Most small businesses are owned by individuals and banks want to assess their characteristics such as honesty, attitudes, willingness and commitment to pay back monies when they are due. They usually use the applicant’s credit history and credit score. Bankers are looking for a reliable borrower who demonstrates responsibility and with a good credit history. This is similar to a background check most employers would perform on a potential employee. Bank uses their internal records, credit reference bureaus, external references and even the internet to obtain information about the firm, owners and management.

If you have the history of poor business management or major litigations for bad debt, why should bankers give you someone’s life savings as a loan?

I know most applicants would say they are a good person, but let test you against the other five conditions.

2. Capacity to repay the loan

Capacity relates to the borrower’s repayment abilities. Using the past track records, experience and current situation, lenders want to assess the borrower’s ability to repay the loan principal and interest when due. Financial and non-financial information are used for these purposes. This condition can disqualify many new small businesses as they would either lack the experience or acceptable track records. Capacity also checks the ability of the business owner(s) and the senior management. Can the management operate this type of business?

Whiles profitability is important to them; bankers will start with cash flow management. You can read about How to improve Cash flows in Small Business or Causes of Cash Flow Issues in Small Business

3. Capital base of the firm

This evaluates the financial condition of the borrower through owner’s’ investment in the business. The greater the firm’s net worth, the lower the financial risk to the provider of the business loan. In other word, bankers want to access the level of money owner(s) have invested in the business. Imagine requesting banks to lend D500,000 on a business where the owners invested only D100,000 (gearing ratio of 83%). If the business goes down, the bank loses 5 whiles the owner would be 1; that is not fair play.

4. The collateral or protection available from the credit

This reviews the extent to which the borrower will or can pledge assets or a guarantee to protect the bank in case of default. Collateral includes property, lieu, government guarantee, insurance etc. In most cases, bankers prefer collaterals with value more than the loan amount of at least by 120%. If the business is owned by high net worth individuals, banks can sometimes accept the personal guarantee of the shareholder.

5. Business environment and conditions

This assesses the macroeconomic and local business conditions that have a bearing on the small business performance in the future. What are the current and forecast economic, technology and regulatory trends in the borrower’s business environment? What could be the potential effect of these trends on the business performance in the future? Interest rates, foreign exchange rates, inflation, GDP growth, new regulations, value chain, innovation etc.

Many banks had cut their lending to small businesses and individuals during the 2008 financial crisis.

6. Compliance with the law and regulations

This reviews the legality of the credit agreement and, in particular, the adherence to the regulations and law pertaining to the loans. This is a legal risk which can focus on areas such as ultra vires (beyond the power). The ultra vires problem arises where the borrower has not got the legal right to enter into a particular type of transaction. This can be supported with formal approval such as board resolutions or review of company article of association.

Compliance can also include the regulatory requirement such as filing and paying government tax, filing annual accounts, environment, social and safety practices etc.

Bankers usually develop a comprehensive list of each of these conditions and make a decision either using a checklist or credit scoring system. This technique is more suitable for small business loans. Corporate loans are usually assessed with more robust formal models such as predictive models and credit rating.

Well, the next time you are planning to apply for a small business loan, consider assessing yourself against these conditions.