Sometimes I receive a request to prequalify a customer for a loan. My first question is naturally, “What is the project?” I am then frequently told there is no “project,” but simply, the member wants to know how much they can borrow based on their income and net worth. Unfortunately, business lending doesn’t follow the same patterns as consumer lending, and it isn’t as simple as collecting basic personal data and calculating a few metrics to establish approval.
In business lending, project matters in everything. A member’s net worth, income and experience may be adequate for $1 million real estate request, but may be inadequate for a $1 million line of credit. Business requests aren’t straightforward for preapprovals, because each business has different ways of generating revenue, different expenses, and different cost structures in general. Simply put, each business loan request will require different personal resources to support the credit risk.
One tool that can aid in evaluating a business loan request is projections or a pro-forma. A pro-forma is synonymous to projections. While I don’t think there is much of a difference, I tend to personally think of a projection or budget as an annual summarized estimate, and I tend to think of a pro-forma as a month-to-month budget estimate. In most (but not all) real estate requests, generally an annual projection is adequate, but for commercial, industrial, and agriculture requests; having monthly projections are important.
When a request is vetted with a specific project and a projection/pro-forma in-hand, it becomes much easier to provide advice as to whether the request is likely creditworthy. But, one should always take projections and pro-formas with a grain of salt, and always keep in mind, it is a projection at best, and not a guarantee the estimated performance will result. I cringe when I see credit officers sign approvals for troubled borrowers, simply because they provided a new budget that suggested this year they will finally be profitable!
A projection or pro-forma should be accompanied with assumptions of how they arrived at the resulting revenue and expenses. Assumptions are necessary so the logic behind the projections can be assessed.
Once I was given a request for a restaurant, and this borrower had operated several other successful restaurants in the area. He gave me a pro-forma for a new restaurant he wanted to start, but it didn’t explain to me how he arrived at his revenue projections. I asked him, “What is the average charge for a lunch meal? What is the average charge for a dinner meal? How many tables? How much turnover per table?” He urged me to take faith in his projections based on his past performance, but I explained to him why I needed that to review the request. He kindly agreed to try and fill in the additional details for me. When he came back, he said it wasn’t economical for him to start the restaurant! It turns out he couldn’t fit enough tables into the building he wanted to buy; thus, he would be unable to generate the revenue he was projecting!
To get started with a business request, having some sort of projections are key to initially assess underwriting. Each business request has unique risks, which is why we can’t really underwrite a borrower for a preapproved amount of money. The projections will help us understand that risk, and whether the borrower can backstop those risks. But, we need to take those projections with a grain of salt and understand the assumptions used in the projections.