The phrase “beauty is in the eye of the beholder” is widely credited to author Margaret Wolfe Hungerford, although various forms of the expression have been circulating since the third century B.C. Like beauty, creditworthiness is ultimately in the eye of the lender.
Though there may be common borrower characteristics that will universally appeal to bankers — robust cash flow, large amounts of liquid collateral — the particular importance that each lender assigns to each credit metric may vary considerably. Some banks may view larger business borrowers more favorably; others are impressed by a consistent track record of operating results.
Further, banks often specialize in underwriting particular market segments, some targeting commercial real estate loan production, while others concentrate on agricultural lending or residential and consumer credit.
Given the wide disparity of borrower types and their varying credit needs, bankers’ approaches to analyzing businesses are best governed by rules of thumb rather than hard-and-fast criteria. A trend of increasing sales would be meaningful for most industries, but for others, the top line doesn’t tell much of the story.
Farms and gas stations illustrate the point: given the volatility of feed and gasoline prices, revenues for these businesses can easily rise by 50 percent in a matter of months, but cash flow may not concurrently benefit due to rising input costs.
“Ultimately, it’s cash flow that matters most,” says Steve Faulhaber, regional vice president of Peoples State Bank in Menomonie, Wis. Because most of his bank’s borrowers are also using the bank as their primary place of deposit, Faulhaber doesn’t need to wait for updated borrower income statements to get a sense of a company’s operating performance. Most of the time, he can discern changes in a company’s health by simply tracing fluctuations in its account balance.
Faulhaber notes that declining balances are a reliable leading indicator for predicting delinquencies. After all, he says, “as long as the borrower still has a deposit balance, he shouldn’t be missing a loan payment.”
When he reviews financial data, Faulhaber prefers to review tax documents in lieu of company-prepared statements, for a simple reason: it’s a conservative way to underwrite. While some borrowers might be tempted to overstate their income in order to qualify for a bigger loan, they are certainly less inclined to do so on tax returns, where the practice would likely result in sending larger checks to the Internal Revenue Service. For the vast majority of prospective business borrowers that do not report positive incomes on their tax returns, new credit extension is a small probability.
The accelerated depreciation schedules used for tax returns also result in conservative asset valuations. While a diligent underwriter will require collateral appraisals and make an on-site visit to every property pledged against a loan, a favorable debt-to-equity ratio gleaned from the tax return balance sheet often provides additional comfort.
As a general rule, strong balance sheets are also correlated with healthy liquidity positions because a surplus of unencumbered assets will enable a company to readily obtain additional cash from its lenders.
To Faulhaber, the most important quantitative metrics in underwriting are cash flow and collateral values. Credit reports, loan repayment history, cash balances, and new asset acquisitions are also significant factors. Ideally, he prefers to lend to businesses with an operating track record of at least several years. “A business doesn’t thrive just because it’s in the right industry. A lot of success comes down to the quality of its management,” he explains.
Experienced commercial bankers know that thorough credit analysis requires a holistic approach that transcends simple number-crunching. If a business is known to have good relationships with its customers and vendors, it’s also more likely to make its loan payments on time.
For this kind of work [loan underwriting], says Faulhaber, “the college finance majors don’t always have the best skill sets — ultimately, street smarts help a lot more than book smarts.
”The biggest concern I need to address in my due diligence is whether people are playing level with me.”
James Adams is a senior analyst at Sageworks, a provider of credit risk management, loan loss reserve and stress-testing software to financial institutions. Adams is also author of Waffle Street: The Confession and Rehabilitation of a Financier, a humorous examination of money, banking and economics.