The Banker Will Have 3 Questions

A senior lending officer at a large commercial bank said to me some years ago that when he reviewed loan application packages, he wanted the answer to three questions:

1. What is my primary source of repayment?
2. What is my collateral or other security?
3. What is my third source of repayment?

By primary source of repayment he meant the cash flows to cover the borrowed money. That could be profits from new equipment purchased with the borrowed funds, higher volumes for which a credit line would finance accounts receivable and inventory, additional sales and margins from new or expanded plant capacity, current profit levels, and the like. The cash flow projections were most important here.

The second question as to collateral is easy to answer. The collateral or other security is the asset financed, like the inventory, receivables, equipment, land and buildings, maybe sinking fund payments, and so forth. And the banks use some simple rules of thumb that my clients can easily incorporate in our loan applications. Rules like: borrowings will be limited to 80% of the current accounts receivable, 50% of the inventory, debt coverage and fixed charge ratios higher than 4 to one, and so on.

But, it is the third question that is most important. Even after showing good primary repayment and solid collateral, which were simply minimum requirements to fund any borrowing, the issue became what is the added source of protection? If the primary source of repayment does not work, meaning that the cash flow projections are not met; if the collateral proves inadequate: if real estate declines in value, if inventory is damaged or won’t sell, if receivables are slow being collected; what is the added source of protection for the bank?

That third source of repayment, in privately owned mid-market companies (like my clients: $2 million to $50 million in revenue) can be overcollateralization, liens granted on other assets, and the like. But, as a practical matter, what it really means is the bank wants the personal guarantee and assets of the owner as that third source of repayment. Over the years the bank had done a number of studies on its mid-market clients, and had learned that the single most important statistic, as to whether the business loan would be paid back under its original agreed terms, was the personal credit history of the owner. When granting or renewing a credit was a marginal decision, the owner’s personal credit was the deciding factor in the bank’s decision to make or deny the loan.

I repeat: at the margin, assuming the primary source of repayment was credible, and the collateral and covenants met the bank’s standards, the credit committee decision was swayed by the personal credit history of the owner. The bank would require the guarantee simply as a matter of policy, but it was the personal credit that caused a favorable or unfavorable decision at the margin, even for very large (multi-million dollar) loans.

As my banker friend said long ago (I paraphrase here because it has been a while): “If he has trouble paying his personal bills, he will have trouble with our loan to his company. If his personal financial house is in order and has been over time, we are comfortable that we will be paid back and we are willing to take the risk”. Still true today.

Sometimes, when I am working on new loan packages or refinancings for clients, the first place we focus is the personal credit, because at the margin, it makes the difference.