Bar Napkin Analysis for Member Business Loans

As a CUSO that helps smaller Credit Unions with the startup of their Member Business Lending departments, after drafting a loan policy, the next thing I hear is ‘What now?’ This is a loaded question, because every member and his or her request is going to be different, but there are some basic steps that you can follow to help you determine the credit worthiness of a member’s request before too much time is wasted.

Step 1: Don’t start out quoting rates!! Starting out quoting rates before you know the details of the loan request is setting yourself up for failure. First, a member that is shopping for the best rate isn’t likely to be with your Credit Union for the long haul. Smart business owners know that there is value to a good relationship with their lenders, and if that comes down to an extra .5% on a loan, they will be willing to pay it. If they walk, you will likely see them back in a year when they find out their bargain basement interest rate wasn’t all it cracked up to be. Second, interest rates should be reflective of the structure and general risk of the loan. Quoting the same interest rate for a 5-year single family residential rental loan as a 12-month term line of credit that is tied to a borrowing base makes no sense. The latter is going to require significantly more time to monitor and service, and inherently carries more risk.

Step 2: Have your member complete an application. Pactola’s website, www.pactola.com, has applications available to download for both commercial and agricultural loans, and each include a complete checklist of the items that your member will need to provide. These items will get you started on your bar napkin analysis of the credit request. If your credit union is a subscriber of Pactola, shoot us an email with your logo and we can get these applications customized for your Credit Union as well.

Step 3: Evaluate the collateral. Depending on your Credit Union’s loan policy, you will want to evaluate the collateral to make sure it is within your loan policy’s limits and is readily marketable. If it is equipment, do you need to discount the estimated value due to age or condition? You will then want to look at the maximum loan term, amortization, and LTV your policy will allow. Let your member know these terms so they know how much equity they will need to bring to the deal, and that those terms are how you will initially analyze the loan, but are not guaranteed. These terms are relatively fluid until closing.

Step 4: Time to analyze. Now that you have received the historical (or proforma, if a start-up) financials on the business, it’s time to analyze. Ideally, the primary source of cash flow is going to come from the gross revenues of the business. This can be rental income, sales of goods, cattle sales, etc., but this is how we want our debt to get repaid. Starting with the Net Income, add back any Depreciation expense, Interest expense, and Amortization expense. You have now calculated the business’s Net Operating Income (NOI), or EBIDA. This is the cash the business has to service its debt. Again, this is a bar napkin analysis just for you to see if there is merit to the request; these calculations can get much more complicated depending on the business. You will then calculate the estimated Debt Service Coverage Ratio, or DSCR, which is the NOI divided by the proposed debt service. Ideally, you want to see this above a 1.20x. If they are in that gray area of 1.10x and 1.20x, it may be worth looking at further; however, if it is below the 1.10x level the primary source of cash flow starts to be put into question.

Step 5: Look at the Guarantor’s resources. The secondary source of cash flow after the business revenue is likely going to be your guarantors’ cash flow and resources. Do they have a strong equity position or are they highly leveraged? Do they have liquidity to help supplement any cash flow shortages? What are their assets? Do they have diverse income sources, or are they solely reliant on the business for cash flow? Although a full personal tax return spread is not necessary at this stage of evaluation, you can usually get a good feel of the guarantor strength by answering these questions. Having a strong guarantor to backstop a loan is especially important when the cash flow from the business is weak or erratic.

Step 6: Underwriting. Once you have a signed term sheet and all of the necessary items from your borrower, it’s time to dive into underwriting. Business loans are evaluated based on the 5 C’s of Credit: Character, Capacity, Capital, Collateral, and Conditions. If you have a new business lending department or just don’t have enough staff resources to do underwriting in house, Pactola can act as your third-party underwriter.

Whether your Credit Union is just starting its member business lending department or you have found yourself struggling with initially evaluating a loan request, these steps can help get a good conversation going with your member and prevent wasted time on poor requests. Pactola is here to help in making your lending department great!

Is EBIDTA the Holy Grail of Understanding a Company?

I remember the first time I was in a classroom at the bank I worked for in Jefferson City, Missouri.  I was a seasoned banker, but quite a young pup when it came to the commercial and agriculture side.  One of my banking mentors taught a short class on how to figure the Debt Service Coverage Ratio (DSCR).  This is figured by taking EBIDTA (Earnings Before Interest Depreciation Taxes and Amortization) divided by the annual debt service requirements for the firm. 

I was amazed.  I was looking for the holy grail, the excalibur that I could use to dissect the financials of a farmer or a business and gain clarity of whether the company could manage the proposed debt requirements for the loan request.  I thought I had just conquered commercial lending.

EBIDTA or another similar term, Net Operating Income, is not only used in calculating the DSCR but is also used in figuring value by using Cap Rates.  So now I was even more excited that I could not only see if the company could service its debt, but I could get a value of the company or the collateral as well.  Now the conquering of commercial lending turned into a mastery of the subject.   High fives all around.

My mom always warned me about getting "too big for my britches”.  That is good advice, as life is a constant learning experience, and just when you think you are really solid, get ready for a fall.  This was the case with my supposed mastery of the subject.  I quickly learned there is no holy grail, only road signs to help you determine the health of a firm.

It all came clear with a manufacturing company who wanted to acquire a new machine.  I did all the due diligence and determined that the customer could historically service his existing and proposed debt based upon my EBIDTA and DSCR calculations.   I completed my write-up and sent it to my boss.  The wise sage requested to see a detailed depreciation schedule.  I wondered why, since you could get the whole depreciation figure from the income statement without looking at the schedule. 

The sage called me in the next day and said, "Young grasshopper, the company has three pieces of machinery that will need to be replaced next year according to their history and depreciation schedule.  Where will the capital come from for the machinery?"  The manufacturer had equipment or parts that went on larger pieces of equipment which would wear out every two years and need to be replaced.  Since the replacement would be completed and benefit the company beyond this fiscal year, they capitalized and depreciated the asset instead of expensing it as a repair item. 

So, I had failed to account for that planned expense.  Calculating it in took my slam dunk deal into questionable territory or maybe a denial.  I trudged back to the company's CFO to get more answers. 

An important factor in analyzing a company is to look at required and necessary capital expenses that will be required to maintain the current level of production.  For my firm, the $150K for machinery press and drill parts was necessary for keeping three key machines running to continue production of granite countertops; otherwise, the company could not machine cut the countertops and would have to cut all by hand.  This would either require more staff or less production, either of which would drop the NOI substantially.  We had to uncover how those items would be paid for.  In this case, the company had set aside most of the money and was planning to pay for the last 1/4 with cash from several large sales they were to get in the next two months. 

This was a case in which only looking at the EBIDTA or NOI to figure the DSCR was not enough.  It required a further look into the planned capital expenses to determine the adequacy of cash in the company.

It is possible that the EBIDTA number can be understated.  I have banked with some hotel operators, who will expense any repair or improvement item for the hotel:  light bulbs, replacing broken furniture, new carpet, or repaving the parking lot.  All of these have different treatment accounting-wise.  The light bulb is a consumable item that should be run through the repair expense.  Replacing broken furniture can either have an expense for the broken piece depreciated out and the new one capitalized, or one could just expense the new one in the repair line.  The carpet should be depreciated over the expected life of the carpet.  In the case of this hotel, it was around 5 years.  The parking lot had an expected life of 15 years. 

If all of these items were in the repair expense, it would be counting repair items that would not necessarily be occurring every year.  Perhaps you may want to do that if you have a property that is requiring large amounts of ongoing capital investment year after year.  But in most cases, the one-time expenses should be pulled out, and a capital expense allowance can be used.  This is an estimate that on an average given year, some percent of gross income (usually 3-5%) will be spent on capital improvements for the property.  Using this method will help average out the EBIDTA in years when improvements are made and expensed, and in those years when no additions are done.

New Business Ideas: How to Determine the Contenders from the Pretenders

A client sits across your desk and pours out a business idea that he needs financing for.  At this point, you don’t know if his idea is destined for failure or will be the next success.  After all, most successful businesses once started with someone with an idea sitting across the desk of a loan originator requesting a loan to get started or to go to the next level. 

Commercial and ag lending is humbling.  You can review the facts and make the best judgment possible on the loan request, but you never know if it was a good decision until much later.  The only good loans are those that eventually pay off.  So, hindsight is always 20-20, but there are some signs you can look for to determine if the idea presented to you is worth an investment in the form of a loan from your institution or not. 

Experience and Education.  Does the customer have experience in the business field that he wants a loan?  Borrowers who have the training and work experience in the field they will be operating in have an advantage compared to those who do not.  You would not want to give a loan to someone to open a medical clinic that does not have the background to operate the business.  This principle will apply to whatever business you are looking at. 

Not only do you need to look at the background of the borrower in front of you, you need to look at the experience and training of his key personnel compared to the skills required to make the business work.  For example, if you had a few good cooks with only culinary skills who want to open a restaurant, there may be some challenges since they do not understand such things like managing staff, running the “front of the house,” and optimizing cash flow.

Equity.  Successful business owners have “skin in the game.”  This can come from cash, property, or equipment they are bringing into the business.  You should run from any loan request where the borrower is expecting you to provide all the proceeds for the project and there is no investment from the borrower.  If the borrower’s idea is good enough, the request is for a venture capitalist not a credit union.

Earnings.  Good loan requests on established businesses will have a history of earnings that can support the request.  The challenge is what do you do when you are dealing with a new business venture or a huge increase in the business where there is either no history or not substantial history to support the request? 

A good lender will look for mitigating factors to combat this risk.  How reasonable is it that the business will succeed?  Does the borrower have other source of income to sustain his life while the business is in its early stages?  Can you look at some option like a government guarantee to reduce your credit union’s exposure?

Ease.  I call this the “ease test.”  Pretend that the only source of loan money was from your dear, wonderful grandmother.  She has worked her entire life for her meager nest egg and now is relying on you for investment advice.  If you took her money and lent it to your borrower, how easy would it be to explain to her your lending decision?  Would she be proud of your action?  Or, would you have to spin a verbal tale to her to justify your actions?  If you want to be a little more scared, you should be prepared to explain your decision to your management or to your regulator. 

Remember lending is more of an art than a science.  I cannot tell you that every request you have that meets these tests will end up as a good loan.  I also cannot tell you that if a request was lacking in an area or two if it will turn out to a problem loan.  I can tell you that lending involves looking at the overall picture and applying a good dose of common sense.