Bank considerations for SME loan applications

How banks judge SME loan applications - Crowe Horwath Ireland

The 5Cs of bank lending criteria

Banks look carefully at SME companies before they lend money, especially in more challenging funding environments like the present one. The traditional approach for assessing loan applications was based off five primary factors – the “Five Cs”. These are:

  1. Character
  2. Capital
  3. Capacity
  4. Collateral
  5. Conditions

The “Five Cs” gave bankers and borrowers a clearly mapped out criteria when considering any lending proposal.

The Irish banking environment has changed considerably since the recession. Greater concentration of banks in recent years means SMEs have less choice. In June 2017 the Central Bank reported a 32% increase in new SME lending but at the same time SME rejection rates have also increased.

Our SME clients consistently tell us that access to investment and working capital is their number one concern. So for an SME looking to raise senior bank debt, ensuring they put forward the best possible application is critical. However, there is a considerable time investment involved and a level of sophistication required when preparing loan applications. With that in mind, our corporate finance team have outlined some of the key components of the “Five Cs” for SMEs to focus on before starting the loan application process.

1. Character

Ownership structure: Include a clearly defined group structure that outlines the ownership and corporate constitution.

Track record: Tell your story and highlight key milestones of your successes. It is essential in articulating your ability to produce a well-positioned product together with the competence and business acumen to deliver profits.

Management team & organisational structure: Include biographies of the organisation’s key people and their business experience. Consider what safeguards are in place to protect against loss of critical team members. Demonstrate the procedural processes that make the business tick.

Culture: Articulate your business culture and the measures you take to protect and enforce the organisation’s integrity. This will ultimately feed into the bank’s risk assessment.

2. Capital

Purpose: How much capital is needed and how will it be used? Do you need a short term working capital facility (overdraft / invoice discounting) or are you looking to finance a long term asset (term loan)?

The debt structure and loan term will vary depending on use of funds and the risks involved. Consider all the risks involved and assess the cashflows.

Amount of capital needed: Do your research and prudently estimate the amount of capital required. There is little point in underestimating the funds needed and risk falling short because of overly ambitious estimates. Ultimately it will impact your credibility and limit your ability to achieve your goals for the funds raised.

Equity input: Be clear on how much equity you can bring to the deal. Each lender will have restrictions on maximum levels of funding subject to the sectors or product parameters.

Leverage: Every sector and business operates under its own prevailing conditions and market nuances. Lenders will assess the business based on customers, competition and determine an appropriate level of debt leverage on that information.

3. Capacity

Trading history: Historical financials should be easily interpreted to provide clarity on the cash generation cycle. Consideration should be given to financial metrics that link audited accounts to operational performance.

Current trading: It is critical to demonstrate that quality management reporting systems are in place that report up-to-date performance to bridge the gap between audit year ends.

Borrower commitments: Provide transparency on terms, conditions and repayment obligations of any existing debt or loan agreements. Pre-existing debt will impact a lender’s view on available cashflows.
Projected performance: Comprehensive financial projections need to reflect any potential risks and demonstrate capacity to cover repayment schedules. Consider introducing sensitivity analysis to cover all eventualities but most importantly bridge the current and future performance with detailed assumptions.

Debt Service Cover (DSC) / Interest Cover (IC): A strong loan application will demonstrate sufficient “headroom” to cover DSC / IC ratios. In simple terms, free cashflow must exceed scheduled loan repayments.

4. Collateral

Security: What is available to the lender to mitigate the risk of loan default? At its most basic this about defining what can be pledged to protect the lender if a loan is not repaid. Security will be tailored subject to type of loan and can range from personal guarantees to a charge over specific assets.

Loan to Value (LTV): Specific to property assets, LTV is a risk measurement that quickly illustrates the level of security cover relative to the level of debt. LTV is calculated on the open market value of an asset (which should be prepared by an independent valuer). The location and type of property will determine the LTV rate. Lenders will consider the LTV on drawdown but also set residual LTV targets in line with the loan amortisation profile.

Pricing and rates: Well-secured loans reduce lender risk and this will be reflected in interest rates and pricing. Quality liquid assets security will attract lower interest rates whilst loans against unsecured cashflow will command more expensive pricing (and shorter terms!).

Covenants: Borrowers will need to be mindful of continuing to satisfy covenants on leverage, repayment cover on a continuing basis. In certain circumstances, third party or shareholders loans may be subordinated or capital expenditure levels may be restricted to agreed levels.

5. Conditions

Customers: Consider your customer base and the spread of revenues across your service / product base. What are your standard payment terms and how do you mitigate working capital lock up (i.e. extension of supplier credit)?

A strong line of “blue chip” business with one customer gives visibility on good quality earnings and can act as a reference point for other customers. But equally, business owners should be mindful of the pitfalls of customer concentration – what are the implications for loss of key customers.

Suppliers: Think carefully about your key suppliers and the factors and risks impacting their business. A well-managed SME appreciates the importance of preserving a key supplier relationship but also avoids becoming dependent on a third party. Understand your supplier terms, maximise these whilst making sure you pay on time.

Competitors: Know your competition and track their service / product development. Articulate the key differentiator that drives your business success.

Market: What macro-economic and / or political factors influence your business? An accomplished SME understands the legislative and regulatory changes that will impact its business model – so identify and understand the risks and threats and communicate the mitigants for your business.

Our corporate finance team has extensive experience assisting SME clients prepare loan applications and providing guidance through the different steps of the loan application process. In recent years we have seen a shift from senior bank debt to a range of alternative sources of finance. We help clients assess their individual requirements and provide guidance on the best source of finance to suit their needs.

If you are looking to raise finance and require assistance, or are looking to refinance existing debt, contact a member of our corporate finance team.