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TAKING THE MYSTERY OUT OF

COMMERCIAL LOAN UNDERWRITING

Commercial lending differs from most


consumer lending, such as residential
mortgage lending, in that there are no
hard rules or ratios that make a loan
either acceptable or unacceptable.
Commercial lending is a bit more
of an art than a science. However,
the underwriting process of sound
commercial lending is not the mystery
it may seem to be. It is simply a
process of information gathering (or
due diligence), financial analysis, and
the making of informed judgements.
The process described in this article
would be typical for a new client, with
a more streamlined process for an
existing client that a bank already
knows well.
While the process described may
seem rigorous, remember that banks
operate on very thin margins. Net
interest income margins are typically
around 4%, as compared to a
corresponding gross profit margin for
most
businesses
of
anywhere
between 15% and 50%. This,
coupled with the fact that banks are
highly regulated and are lending
depositor and shareholder money,
makes it clear that there is little room
for write offs of bad loans. That is why
there are typically several potential
sources of repayment for a commercial
loan cash flow, collateral, and
guarantors.
To analyze these repayment sources,
the bank must first get to know and
understand the prospective borrower.
The due diligence process begins by

meeting with company management.


General information is gathered for
an understanding of the business
discussion regarding ownership,
management, products and markets,
financial information, and brochures on
the company. This provides necessary
background information, and gives the
lender an impression of managements
understanding of the business. Does
managementunderstandthecompanys
financial
statements,
competition,
competitive advantages, etc.?
The financial information typically
collected includes year end balance
sheets
and
income
statements
for the past three years, the most
recent interim financials along with
corresponding statements from the
prior year, the annual budget, business
tax returns (if year end statements are
unaudited), accounts receivable aging,
and possibly accounts payable aging.
In addition, for most privately held
businesses, the owner(s) guarantee
the debt, so current personal financial
statements and personal tax returns
are collected. All of this information will
be used later by the lender as part of
the financial analysis.
Ideally, at least one meeting will be
held at the business location so a tour
of the facilities can be conducted.
This will allow for observation of
the general working environment,
equipment quality and upkeep, and
inventory control and management.

Furthermore it provides an insight


into managements understanding
of the operations.
The due diligence continues as the
lender, if unfamiliar with the industry,
does general industry research as well
as investigating trends or changes
affecting the industry and specific
threats to the prospective customer.
This investigation may also include
contacting any significant customers or
vendors of the business.
In addition, information will be
garnered from outside credit sources
such as Dun
& Bradstreet for the business and
credit bureau reports on guarantors
to learn of any historical payment
problems. Uniform Commercial Code
searches are also done to determine if
other creditors hold superior lien
positions.
If positive results are obtained, a
written analysis is done by the loan
officer using the information gathered.
This is the analysis that will be
reviewed by the loan committee or
used to document the lenders
individual loan approval. The basic
part of this written analysis would
include sections on the

YOUR SUCCESS COMES

history of the business, management,


products and markets, loan purpose,
financial analysis of the business,
collateral analysis, and financial
analysis of any guarantors. The goal
of this analysis is to reasonably
assess the likelihood of continued
future success for the company.
The history of the business gives an
idea of the companys evolution,
historical success and longevity. In
addition, the type of ownership (sole
proprietorship, S Corp., LLC, etc.)
will shed light on what financial
information needs to be examined
and how the loan should be
structured and possibly guaranteed.
The management assessment will
include not only the owners but
also other key personnel. Relevant
information will include individuals
names, areas of responsibility, tenure
with
the
company,
and
prior
experience. The goal is to not only
determine managements experience
level, but also its depth. In some
businesses, there is a large reliance
on a key individual, and this risk
needs to be addressed, possibly with
life insurance on the key person.
The companys product and market
should also be well understood.
What exactly do they do? The
analysis should articulate how they
differentiate themselves from their
competitors.
Is
the
company
positioned as a low cost provider

or do they provide higher


quality, better service, or

faster turnaround? Who are the major


competitors and what are barriers to entry
for new competitors? Who are major
customers and industries sold to, and is there
a major concentration risk to be analyzed?
How are sales generated - by inside sales
people, outside sales reps, or distributors?
Are revenues cyclical with the general
economy and/or seasonal? This should be
considered when structuring loans and loan
payment requirements. All of these types of
questions need to be answered, thought
through, and analyzed, to identify areas of
potential market risk.

The purpose of the loan needs to be


considered,
so
the
appropriate
credit
structure is used. For example, working capital
needs caused by growth should be funded by
a line of credit with interest only payments
required, while an amortizing term loan better
matches the life of longer term assets such
as equipment or real estate. Also, a brief
schedule of the sources and uses of the
transaction may clarify the credit need.

A significant part of the analysis is based on


the financial statements. Banks use industry
specific spreadsheet software to analyze
these statements, looking at several periods
for trends and significant changes as well as
generating
various
financial
ratios for
analysis. While this analysis can be in depth,
a few key pieces of data are fundamental.
For example, major items on the balance
sheet that are

YOUR SUCCESS COMES


examined include: liquidity, the
ability to meet current obligations,
using the current ratio (current
assets divided by current liabilities)
or working capital (current assets
minus
current
liabilities);
and
leverage, the companys net worth
position relative to its liabilities,
using a debt-to-worth ratio (total
liabilities divided by net worth). An
acceptable current ratio or debt-toworth ratio depends
on
the
industry and the life cycle of the
company. For example, is it a
relatively young company, a recent
acquisition, or a fast growing
business?
Consequently,
these

types of ratios are looked at


for trends and are measured
against industry norms (banks
typically use Robert Morris &
Associates data). Similarly,
days outstanding of accounts
receivable,
inventory
and
accounts
payable
are
measured versus
industry
norms and previous period
levels. Large variances can
indicate
problems
with
collections, inventory controls
and/or cash flow, which would
need further explanation.

The income statement is analyzed to


look at items beyond just sales and
net income growth or compression.
For example, gross profit margins
and operating expense levels are
compared to industry averages and
examined for trends. Management
needs to have plausible explanations
for changes to these items relative to
business strategies e.g. sales are up
but gross profit margin is down and
sales expenses are up due to
penetration into a new geographic
market, or

www.firstbusiness.co

economic and market conditions e.g.


raw materials costs rose and it took
time to work through the pricing in
contracts already in place.
Cash flow is the primary source of
debt repayment and paramount in
importance in most loan situations.
Cash flow is different from earnings, in
that
noncash
items
such
as
depreciation
from
the
income
statement, balance sheet changes
such as growing receivables and
inventory
levels, and other debt
payments need to be factored in.
The banks software calculates cash
flow using both the income statement
results and balance sheet changes
and is used in this analysis. The
lender analyzes historical, current and
projected ability to service the debt as
well as capital expenditure needs and
any other obligations which must be
paid.
Collateral analysis is a basic part of
any loan analysis, in that it provides a

secondary source of repayment should


the expected future cash flow not
come to fruition. The bank will look
at the values of the companys assets
on which it has a lien, and apply a
discounted
value
for
collateral
purposes. The bank would usually not
lend beyond that amount unless there
would be a strong guarantor or other
collateral. Beyond experience and
industry
standards
for
discount
factors, appraisals can be done for
both real estate and equipment to
aid in this analysis.
Finally, the financial statements of
any guarantors need to be analyzed
to see what additional strength the
guarantors bring to the deal. Beyond
the guarantors net worth, personal
liquidity is the key. Cash or marketable
securities provide liquidity to cover
temporary cash flow shortages, or can
be a secondary source of repayment
on unsecured or under-collateralized
loans. Analysis is also often completed
on the guarantors personal cash flow,

which goes beyond just personal


income, factoring in other items such
as required personal debt service.
In the end, a conclusion needs to
be drawn and a decision made. The
science is in the process outlined
above. Now the art of the judgement
of all these factors is performed and a
final approval or denial is made. There
is rarely a clear cut situation. Even
for a strong company, there may be
a question mark about the business
longevity,
management
depth,
competitive threats, a concentration
with one customer, or issues on the
financial statements. These pluses and
minuses are weighed and a decision
is made. In the end, this is where the
lender and the loan committee prove
their worth and provide well structured
and prudent loans to their community.

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