Think of your banker as one of your most important suppliers.
By Don Humphrey
A FEW BANKING STATISTICS:
Bank failure count: 30 so far in 2010, 140 in 2009, 25 in 2008 and 3 in 2007
FDIC “problem institutions” watch list: fourth quarter of 2009 grew to 702 from 552 in the third quarter; this is the highest since the savings and loan crisis in 1994
One of the fundamentals of business success is having great relationships with key suppliers. In the precast industry, a precast producer’s key suppliers include cement, aggregates, steel and reinforcing vendors. For suppliers they include rubber, steel and plastic vendors. Another key supplier – and one that is often overlooked – is your banker.
You should interact at least as much with your banker as you do with your other key suppliers in building the strongest possible banking relationship.
In simple terms the bank is a supplier – it rents money to you. The more money you borrow, the more your banker is your most important supplier.
How important is your banker? Consider this: If your cement supplier suddenly goes out of business, you can probably find another cement supplier the same day. If your bank shuts down, it will likely take you months to find a new bank, if you can find one at all.
Banking industry & banking climate
Some say this is the worst banking climate since the early 1980s when the prime rate was 18 percent. Others are saying this is the worst since the Great Depression. The bottom line is that borrowing money today is the most difficult time for most of us during our business careers.
5 C’s of credit
The banking industry uses what is called the “5 C’s of credit” to analyze a borrower. Instead of “paint by numbers” it’s “lend by numbers.” They cannot and will not hang their hat on sad stories. The 5 C’s are Character, Capacity, Capital, Collateral and Conditions. Two more – Communication and Comfort – have been added here for extra measure.
Understanding the C’s of credit will make you more effective in building a strong banking relationship. You should know how you measure up before you talk with your banker. Know your weaknesses in these areas and be prepared to talk with your bank when it questions you about a weakness. Discuss the actions you are taking to address this weakness.
Character. Character is one of the intangible C’s of credit. It is hard to measure; the bank cannot put it into a ratio. What is the character of the company management? Character includes management’s reputation in the industry and the community; the way you treat your employees and customers; the way you take responsibility; and your timeliness in fulfilling your obligations.
Character is really about you and your leadership in your business and personal life. The bank is trying to determine what kind of a captain you are in navigating your business through the ups and downs, and especially the downs. They really want to know whether or not you will be the last person on the ship in a storm.
Capacity. Capacity is more tangible than Character, and can be measured. The bank is trying to determine the maximum amount of debt you can handle and how the debt will be structured. Remember, banks are conservative. The bank uses financial benchmarks such as profitability, cash flow and liquidity to “measure” what it thinks is your debt capacity. They will want “room” or cushion in these ratios. Know what financial benchmarks your bank uses, how they measure them, and be able to explain these benchmarks so that you really understand them.
The bottom line is that the bank wants to determine the maximum amount of debt and debt structure that it is comfortable lending you – not what you think is the maximum debt you can handle.
Capital. Capital comes in several forms: money invested as common stock; retained profi ts; subordinated stockholder loans. You see your capital listed on your balance sheet as equity or stockholder equity. Stockholder loans will typically show up as a liability on the company balance sheet. However, if stockholder loans are subordinated to bank debt, then these loans should be considered a part of equity or capital. The bank wants to see how much of your capital is in the business. The bank also looks at your personal fi nancial strength when measuring capital. The more you have at risk, the less likely they will lose money and the more likely you can survive
economic or business hardships.
Collateral. This is also very tangible. The bank can measure it. The bank doesn’t want to get paid by forcing you to liquidate collateral; however, it looks at collateral as a secondary source of repayment. Collateral includes accounts receivable, inventory, plant and equipment, and real estate. Banks use advance rates against collateral value to determine if there is enough collateral to support a loan. Talk to your bank about the advance rates it uses. Banks use advance rates on collateral as a guide to determine the maximum amount they will lend you on a secured basis. It’s basically “loan by numbers” to determine a maximum loan amount.
Conditions. Like Character, this is one of the more intangible C’s of credit. This is where the bank will look at anything and everything besides your financial performance: current economic conditions and impact on your company; current economic conditions and impact on the bank; industries that the bank wants to lend to and those it does not; economic or
political hot potatoes that negatively impact the company or bank; environmental exposure; and credit terms and conditions the bank will require to make a loan.
Communication. This one seems so obvious. So why is it an issue? The better you communicate, the better your relationship. And the worse you communicate, the worse the relationship and the bigger the problems. Communicating with your banker is critical. Talk to him regularly. Be visible. Provide all the financial information your banker needs – and do it before he asks for it. Always return his phone calls promptly.
Comfort. This is an intangible issue. It is a gut feeling. From the banker’s and bank’s perspective they must be comfortable with how much money they are lending you. We may think of Comfort as the sum of the 5 C’s of credit. If the bank is comfortable with you, then you’ve passed the 5 C’s of credit.
Banking is a two-way relationship. Make sure you are comfortable with your banker and your bank. If you aren’t comfortable with your bank then fi gure out what it takes to get there. If you simply cannot get comfortable, then you may want to consider changing banks at some point in the future.
Remember: The 7 C’s of credit are critical in your ability to keep the money fl owing from your banker. Fail one C and you could be in trouble. Fail two and you are in trouble. The more you know, understand and meet these 7 C’s of credit, the stronger your banking relationship will be.
A follow-up article on banking strategies will appear in the SEP/OCT issue of Precast Inc.
Sidebar: Red Flags to Avoid in Your Banking Relationship
Banks and bankers look for signals or indicators that a customer might be in trouble or could be heading in the wrong direction from the bank’s perspective. These signals mean that there is a higher chance of collection problems, there is a possiblity of non-payment, or bank auditors might classify the customer as a higher credit risk thus creating problems for the bank.
Watch out for these red flags and do everything you can to keep them from waving over you:
1. Not returning phone calls, not communicating in general – the kiss of death
2. Declining cash flow as measured by EBITDA* (minimum 1.25 to 1 or EBITDA/Principal + Interest) *EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization, a measure of a company’s profitability
3. Inadequate cash flow to service debt and finance company working capital needs
4. Declining revenues
5. Declining net income
6. Net operating loss
7. Deterioration of collateral value
8. Only one way out of the loan – cash flow; the bank needs a secondary source of repayment: collateral based on orderly liquidation value or personal guarantees
9. Declining ratios/financial covenants
10. Concern about the industry you do business in (right now, real estate, contractors and retail are industries that banks are
11. Excessive dividends/distributions to owners and investors
12. Inadequate equity position
13. Inadequate liquidity
14. A/R concentrations (typically any customer with 20 percent to 25 percent or more of total A/R)
15. Increasing total A/R balance over 90 days
16. Don’t have all your banking relationship with the bank lending you money
17. Change in borrowing behavior; borrowing all at once; not paying it back
18. Overdrafts even if you cover it the same day
19. Stop or slow down loan payments to the bank or on accounts payable
20. Deterioration of credit in general
21. Bad credit references
22. Frequent management turnover, especially with persons involved in your banking relationship
23. Past bankruptcies
24. Environmental problems; this could be a huge black hole for your
business, creating huge uncertainties for the bank and potentially exposing it to environmental liability
Don Humphrey of DE Humphrey Associates is a chief financial officer,
controller and consultant with 26 years of precast industry expertise. His
understanding of banking comes from nearly 10 years as a lender with Bank of America. Contact him at [email protected], (925) 961-7631 or visit www.PrecastCFO.com.