June 2, 2009
As a commercial lender, I’m accustomed to asking for a multitude of financial and organizational documents from existing and potential clients.
Often, my admittedly lengthy request soon is followed by questions regarding which documents actually are needed. I thought it would be appropriate, therefore, to provide some insight into the application and underwriting process for commercial financing, and explain why banks ask clients for financial information.
I have been told that, many years ago, some bankers relied on handshakes when extending credit. The extension of credit had more to do with your reputation in the community than it did with your credit score or financial ratios. Documentation supporting the loan request was minimal, but that was how business was accomplished.
Nowadays, lending decisions are based on a variety of quantifiable processes that attempt to determine an individual’s or business’s capacity to repay a loan. Those include, but certainly are not limited to, ratio and trend analysis of financial performance, various calculations of cash flow on both the business and the individual level, and the development of a thorough understanding of the business, including its history and expectations for the future.
Commercial banks have underwriting processes that loan requests follow, which differ depending on the size of the loan (e.g., most banks treat a $5,000 loan request differently than a $5 million loan request) and, most likely, the level of financial due diligence differs depending on what process is followed.
Smaller loan requests typically require fewer financial documents since most banks use credit scoring as a means to streamline the decision-making process. When automated credit scoring is used, an individual’s credit score is crucial since it likely is a weighted factor in the automated analysis. The exact algorithm used to determine one’s credit score is unknown, but there’s plenty of information available to gain an understanding of how to improve a score.
If a loan request doesn’t qualify for credit scoring due to the size of the loan, the type of industry, or a variety of other factors, a commercial credit analyst will review the financial information and prepare a loan presentation to document the decision. In such instances it’s necessary for the client to provide a complete package of financial information, which can include three years of complete personal income tax returns, a personal financial statement, three years of complete business tax returns and/or accountant-prepared financial statements, a business plan and other industry-specific documents such as accounts receivable and payable agings or backlog reports. Although gathering the paperwork can be burdensome, the numbers tell an important story to the bank - a story that helps to determine whether credit will be extended.
The personal tax returns and personal financial statements are needed from the individual guarantors to determine their capacity to support the lending relationship if needed. (Capacity and willingness are two often-discussed terms in commercial lending.)
A thorough analysis is completed to determine the extent to which an individual’s personal cash flow is sufficient to support personal obligations. In addition, the personal financial statement is reviewed to gain insight into the individual’s financial wherewithal. In that context, an individual with a high net worth and ample liquidity is viewed more favorably than someone who is highly leveraged.
Business tax returns and accountant-prepared financial statements are used extensively throughout the underwriting process, and help to determine whether a business has the capacity to repay the loan. The documents also are used to compare the company’s performance against itself - ratio and trend analysis - and its peers. Observations are made regarding liquidity (using the current ratio), leverage (using the debt-to-worth ratio), as well as profitability and cash flow coverage ratios (using a debt service coverage ratio). Although no one metric provides the answer, examining all metrics leads an underwriter to make an informed recommendation.
One of the more challenging aspects of commercial lending is the assessment of an individual’s character. The financial statements and other documents provide ample support for the quantifiable metrics discussed previously, but they also can, surprisingly, provide insight into an individual’s character.
Community banks with local decision-making are better equipped to assess an individual’s character since past actions and reputation within the community often are the best indicators of the willingness to repay a loan. Maybe those old-time practices weren’t so far off.
The banking industry is highly regulated and, as you might expect, banks are facing increased scrutiny regarding loan portfolios given the recent economic turmoil. Community banks’ commercial loan portfolios are under constant review by bank officers, external loan review professionals, auditors and regulators. Unlike consumer loan portfolios, which are evaluated primarily on delinquency and charge-off data, commercial loan portfolios are evaluated based on the current financial status of each individual loan in the portfolio.
It’s important to understand what banks do with your financial information. Unlike the well understood consumer or residential mortgage loan process, where the loan closes and a borrower may never speak to the lender again, commercial relationships require constant communication and flow of information.
A frequent response to my request for financial information is, "Didn’t I give you that last year?" Even though a bank receives financial information at the origination of a loan, federal regulators require us to monitor the current financial status of each borrower. To accomplish the task, the collection of updated financials is necessary.
I’m happy to say that most community banks, including CNB, have remained true to their underwriting standards by asking for the appropriate documentation and using that documentation to make an informed decision regarding the extension of credit. As a result, our performance through the past few years has been exemplary.