In order to become a great business banking customer, you first need to understand how a bank thinks whenever they look at you and your business. At its most simpliest, banks consider 2 things when they look at your business:
1) What is the probability of your business defaulting on your loan agreement – ie not making a payment, not doing what you said you were going to do (Probability of Default of POD)
2) If you do default, what is the probability of the bank losing money as a consequence (Probability of Loss Given Default or PLGD)
To assess this the bank (again most simply) is looking at 3 things:
1) Are MANAGEMENT worth backing
2) Will the business achieve DEBT SERVICING requirements
3) if things go badly, what SECURITY can the bank take to ensure it gets its money back
So how do they measure and assess these things? This is the challenge of banking. Security is easy – your assets have a value, usually provided by a third party. Banks will then apply a policy that dictates their appetite for a particular asset, based on years of experience in good times and bad. The bank feels assumes that it is very unusual for residential property to drop more than 20%, so they’ll lend you 80% of this asset. Commercial property has been more volatile so they might only lend you 65 or 70% of these assets. Business assets have value too. A bank might be prepared to lend you 60% of the value of your debtors for instance.
Debt Servicing is also a calculation. Banks have established policies dictating how much interest you can afford relative to your business’s Earnings. This is an interest cover ratio. They might also speak of Debt Service Cover – this looks at your Earnings and compares it to your interest and the principal reductions (loan repayments). Banks like to march into the future facing backwards, so these calculations are usually applied to your historical results, but sometimes if the future is a high probability of occurring (ie you have some new contracts or assured sales) they might give you some credit for income yet to come to fruition.
Management is not a number, or a calculation. Good management is a driver of success, this is clear, but how do you measure it? Every interaction that you have with your bank is being watched with this in mind. Management is often the small, intangible observations. It is because of this that traditional bankers have trouble conceptualising the possibility of automated business credit assessment. The cleanliness and orderly presentation of your warehouse, your ability to produce end of month financials within 5 days of month end, your propensity to look the banker in the eye when you shake his hand and say hello are all intangible indicators. Things like your knowledge of your market, your hunger for success, your rapport with staff. It all ties to management.
Banks are large organisations and full of people required to make decisions and the bank wants these decisions to be consistent. The more consistent the decision making the easier it is to measure and improve performance at a portfolio level. So banks need to be able to assess management using numbers and information that is readily available to them. Hence, the bank relies very heavily on your financial performance as a determinant of management capability. Are your sales growing, are your margins consistent / growing, do you keep your debtors in check and your inventory levels at a sensible level. They also look at your account performance. Are you staying within your limits? Are you making your payments on time? Is your business reducing its reliance on debt over time (ie producing positive cash flow)? These are all measure that help the bank infer how well you manage your business.
There are 2 key triggers that suggest things aren’t good. Tax office debt and late submission of your financials. Do either of these and you are automatically deemed to be a very high probability of default.
The next time you ask your bank to review your pricing, have a think about how you might look to them. Get this right and you uncover the secret to cheap interest rates….