Demystifying the Credit Approval Process

Demystifying the Credit Approval Process

Like many states in this up and down economic cycle of late, Connecticut has a recent reputation as being a “no growth” state. And while that may be true for our state as a whole, here in Western Connecticut, especially in the Danbury area, we are fortunate to have a vibrant economy that has seen a good bit of growth over the last few years. The business climate here is diverse with a relatively low unemployment rate. We expect this trend to continue in Western Connecticut, which is great news for the small business owners in our area.

Our relatively strong economy means growing opportunities for small business owners to start or expand their businesses. Plans for starting or expanding your business usually hinge on access to capital, sometimes through loans or other credit tools. Many small business owners believe that getting approved for a loan is a mysterious process, one that relies partly on luck and partly on magic. But the reality is loan and credit approvals are based purely on good, old fashioned numbers and formulas, which is the same kind of discipline that you put into your business decisions every day.

As we seek to shed some light on how credit decisions are made, let’s take a look at some of the aspects of loans and credit tools, the approval process, and how the kind of debt you have can impact your application as much as the amounts you owe.

Cash Flow Beats Collateral

Some banks put a heavy weight on your collateral when you apply for any type of credit tool. The more liquid the collateral, the better collateral it is, as that gives the bank confidence they could turn that collateral into cash to cover your credit in the event you can no longer meet your payment obligations. But, in my experience, the best loan decisions are those based on a business’ cash flow. How much income your business has and your ability to fit a loan payment into your monthly budget is incredibly important. If your cash flow is razor thin or your income is largely based on one really big customer that can have a more profound effect on the credit decision than any amount of collateral you could put up to secure the loan. When looking at your cash flow, we like to see a consistent record of income from a diverse customer base that more than covers your fixed costs each month. This gives us more confidence that you will be able to fit in the new loan payment and not result in a situation where you are biting off more than you can chew. That’s not good for the bank. And it’s certainly not good for you. So good loan decisions are based on cash flow more than collateral. Better cash flow – and the longer you can show good cash flow over an extended amount of time – will really boost your chances of getting that credit decision approved.

Properly-Structured Debt

When we think about the debt that you have, we like to think in terms of having the debt match the asset. Ideally, short-term debt should be tied to short-term assets. For example, short-term debt might be business credit cards that help to fund monthly travel expenses for your sales team, who are generating short-term sales and revenue. By the same token, long-term debt should be tied to long-term assets. A loan for capital improvements like new equipment should be connected to a growing market for your business that feeds the need for that new equipment. That growing market should be sustainable over a number of years, just like the loan attached to the equipment that will help you respond to that growth. It’s when short-term debt is tied to long-term assets or long-term debt is tied to short-term assets that business owners run the risk of getting “upside down” on their loan structure. For example, you might want a loan to buy equipment and you finance it with your working capital line of credit. The cost of the equipment will take several years to amortize and it is not the best practice to finance such an asset with a working capital line of credit which matures every year. Equipment should be financed with a term loan which runs over years. Your working capital line of credit is best used to finance such assets as accounts receivable and inventory which turn over quickly. Having the kind of debt tied to the kind of asset decreases the possibility that you’ll run into negative consequences.

Main Credit Decision Factors

There are a number of factors that go into the credit approval decision beyond just cash flow and the type of debt you have. These vary by bank but many are common. They include:

•How Established the Business Is: most banks like to see a long record of healthy cash flow and profits. This is typically a year’s worth of operating history, though there’s no set rule here. What we are looking for is that your business is performing consistently and predictably over time, which boosts the bank’s confidence that you have a reliable business model that can reasonably be expected to continue as such based on past performance. This doesn’t mean that newer small businesses won’t qualify. And it doesn’t mean that those in business for five years automatically do either. But a year’s worth of consistent performance is a good indicator that the business will perform as expected and will be able to meet the credit obligation.

•How Diverse the Customer Base Is: when you have one customer that is more than 40% of your income, that’s a red flag to most banks. If you were to lose that customer, would you be able to cut back enough on fixed costs to account for that loss of income and still make your loan payments? Many small businesses are founded because they have one really good customer who helps to get them off the ground. But the more you can decrease the percentage of revenue that that one customer represents (by increasing the revenue of your other customers), the more likely you are to have the kind of customer-base diversity that reflects well on a credit application.
•Good Financial Mechanics: these go along with the above two factors and show that you are profitable, have good accounts receivables aging, and your fixed overhead costs are in line with the revenues.

•Character and Credit: the hallmark of a community bank is to invest in the local community. And, by its very nature, investing in the local community means that often we do business with people we know. Although we value all customer and prospect relationships (including those folks we don’t know yet) we make a special effort to get to know all of our business customers. That’s not just because we’re friendly, though that’s certainly part of it. But because the more we know you and understand your business and how you operate as the owner, the better positioned we are to help you with all of your needs when they arise. Your personal character matters to us, as does your creditworthiness. And we like to think that because we ultimately take the time to get to know you as a business owner, we are in a better position to provide your financial services than just some faceless website that may know your numbers but not the real you. We think that makes a difference. And since we’ve been serving Western Connecticut for 150 years, we believe our business customers think that makes a difference, too.

If you are a small business owner, there are a number of things you can do to boost your access to the types of credit tools that can help your business grow and be successful. Having good cash flow over time, applying for and managing the right kind of debt, and being aware of the main credit decision factors can all work in your favor when you are applying for credit.

The many facets of credit decisions may be complex, but that doesn’t mean they have to be complicated…or mysterious.

Written by Peter Maher
Executive Vice President, Chief Lending Officer, Union Savings Bank