What lenders want

Nov. 1, 2002
Need to borrow in a difficult business cycle? Here's what manufacturers should know to score a loan.

Need to borrow in a difficult business cycle? Here's what manufacturers should know to score a loan.

Shops need capital investments to survive and thrive in any economy, but especially during a downturn. For the most part, manufacturers depend on lenders to support these capital investments. But companies showing a weak financial performance face an uphill battle convincing lenders to support increased debt levels in light of current trends. That's why it helps to know what criteria a lending institution demands before funding capital expenditures.

Lenders commonly use ratios, debt-to-worth, and cash flow analysis to determine the repayment ability of a potential customer. However, in today's marketplace, they're also reviewing more intangible factors. These include previous payment histories, management, time in business, what adjustments a company has made, the company's previous experience with a downturn, and a detailed justification of the equipment purchase. Lenders are also looking for red flags — potential problems that could be the make-or-break reasons for making a loan:

Poor financial condition of companies. At this point in the economic cycle, it's not unusual to see operating losses in the last 12 to 18 months, decreased revenues, delayed or lost orders, layoffs, and general deterioration. To effectively analyze a company's current situation, lenders need to learn how the company has reacted to the downturn, review its forecast, and understand exactly why the customer is purchasing new equipment.

Payment histories with slowness. The weak economy has adversely affected pay histories of some companies. Again, lenders look at the long-term track record of the business to determine if it can repay a new loan. Lenders do not like refinancing to pay-off accounts that are currently past due and usually determine whether or not to grant a credit extension based on the severity of the recent delinquency and the current financial condition of the potential borrower.

Significantly decreased equipment values. The value of equipment has suffered for well over one year. New equipment prices have dropped drastically, while returned and repossessed equipment levels are increasing. Both of these conditions have reduced collateral values in the market. In addition, losses that are sustained on returned or repossessed equipment are far greater than normal.

For lenders, the lower values affect their ability to underwrite transactions, particularly involving used equipment and refinance requests. Oftentimes, the value of the equipment is not sufficient to collateralize the requested transaction amount. Therefore, lenders must continually review their residual policies to ensure that they are not overly aggressive in structuring these types of transactions.

Increase of specialized equipment. For manufacturers, reducing an operating budget often means turning to unmanned operations. While this may help the bottom line, it is not always beneficial for lending. Automated equipment is typically higher in cost but lower in resale value. That's because "soft costs" such as tooling and accessories don't hold their value like a standard machine tool, creating more collateral risk. This means lenders will carefully consider the configuration of equipment, accessories, and attachments to properly determine what the equipment will be worth in the future.

OEM/customer requests for 6-month zero payment. This greatly concerns the typical lender. From a pure collateral-to-advance perspective, the longer it takes a shop to repay debt, the more risky it is to the lender — income is being accrued, but no cash offset is being received. Equipment historically depreciates most rapidly in the first two years. So the lender is most at risk when skip payments are offered and a contract defaults early in the term.

Overall increase in delinquencies. During the last two years, overall portfolio performance has deteriorated. Although it seems to be stabilizing, delinquencies continue to be an issue for lenders, even causing some to discontinue operations or pull out of the machine tool market. Although many lenders have tightened credit policies or changed the requirements for obtaining credit, success depends on balancing the increased risks with credit enhancements such as structure, collateral, or cash.

Requests for longer-term transactions. As mentioned earlier, longer repayment terms mean higher and longer collateral risks. In addition, a customer often requests a longer and more affordable payment term, but again, this works against the lender's risk equation. The typical transaction averages approximately 60 months, and lenders try to match the term with the credit risk.

Risk analysis
A company undergoing a financial downturn needs to explain to a lender why it's in such straits, what it is doing to compensate for the problem, and what justifies a capital expenditure. Once a lender has all this relevant information, it can evaluate whether it's worth taking the risk in a transaction. At this point, commercial lenders evaluate three types of risk — credit risk, collateral risk, and structure risk.

For credit risks, a lender looks at three financial statements — balance sheet, income statement, and cash-flow statement — and then applies traditional credit-analysis methods. The condition of the balance sheet is related to liquidity, receivables, and inventory turn days/cash cycle; overall debt; and working capital. Using the familiar ratios such as current ratio, turnover ratios, and debt-to-equity gives the lender an indication of the financial health of a company at a specific point in time.

The income statement brings together the company's operations, and a lender uses it for trend analysis as it relates to revenues, margins, and profitability. Schedules for cost of goods sold as well as selling, general, and administrative expenses can provide insight into the causes of trend changes. Individual line items such as materials, labor, and officer salaries can significantly influence a company's performance.

The cash-flow statement, whether provided with the company financials or generated by the lender through a formalized computer program, helps the lender determine how a company generates cash and if it has sufficient cash flow to satisfy current and proposed obligations.

The lender must determine if the company can handle the new equipment request based on its historical numbers or if it has to grow revenue to pay for the new debt.

When analyzing collateral risk, a lender looks at the make, type, age, and price of the equipment a company wants to buy. If a machine is nonstandard, the lender is at more potential risk if the machine is resold in the open market.

Structure risk is something the lender must also take into account. The lender can put itself at significant risk by allowing too many skip or reduced payments, taking too high a residual position on a piece of collateral, or extending credit for too many months.

Lenders will analyze all three risks before making credit decisions. They'll be more cautious about taking on abnormally high structure risk, but more willing to accept normal risk in either the credit or the collateral side of the equation. However, they won't take credit and collateral risks in the same transaction.

In addition to the risk/reward equation, a lender prices in the appropriate profit on a transaction to offset the level of risk. Called a "spread income," the profit essentially equates to the difference between the rate the customer pays for borrowing versus the cost of capital for the lender. The spread income must pay for all of the related costs to the transaction. Therefore the lender also takes into account personnel costs to formulate, process, under-write, invoice, collect, and market the equipment (if necessary).

Sources of repayment
Lenders typically rely on three basic repayment sources — cash flow, guarantors, and liquidation of collateral. Cash flow, in its most basic form, equates to the profit of the company plus any non-cash expenses. Careful analysis of cash flow tells the lender if the customer can repay the proposed loan based on its current financial condition. In many cases, the increased sales/revenues from a new contract are the source of the repayment. If that is the case, a lender may want to review the new contract or get confirmation of orders for the new equipment to justify the credit extension.

In nearly all cases, a lender requires the guaranty of the owners of a privately held corporation, a partnership, or a sole proprietorship. When requested, the lender typically wants a current financial statement on the owners and their personal tax returns. This information lets it consider extending credit based on both the business' and the owner's financial strength.

A strong guarantor can mitigate the credit risk in the business itself. Essentially, guarantors support the debt repayment in the event that the business cannot make payments to the lender. If a machine is repossessed, the guarantor is called upon to make up any deficiency that may exist once the collateral is sold.

A guarantor may not be required if the financial strength of the borrower is strong enough to support the request without any additional support.

Liquidation of collateral is the last and least preferred method of repayment. If the lender is forced to liquidate the collateral, it's usually because the business can't repay its obligation. However, there are instances in which a business decides it no longer needs a piece of equipment to support operations and finds a buyer to assume its debt or to pay off the account.

Enhancements to cover risk
Once a lender has analyzed all of the components of a transaction, it may determine that the only way to under-write a specific request is by using some form of additional security, such as additional collateral, additional down payments, shorter term transactions, delayed funding terms, or accelerated payment structures.

Lenders often take different approaches to the issue of additional collateral. Many take a "blanket filing" on all of the assets of a company. Others take a specific piece of collateral valued at an amount that secures a transaction. Further, some limit the amount of time that the collateral is to be filed against. Lenders usually require additional collateral when the credit risk is high or the collateral package contains a higherthan-normal exposure to the lender.

Lenders often ask companies for additional downpayments. This limits risk by quickly getting cash into the transaction. Many lenders also want customers to put "equity" into a transaction, particularly in a startup business or a high-risk credit profile.

Lenders may also ask to reduce the repayment term to make sure they are covered more quickly from a collateral perspective. In addition, on relatively small dollar advances, it doesn't make much sense for a lender to allow for an extended repayment term.

When a lender requests delayed funding terms from either a manufacturer or distributor, it does this to get more money into the transaction at a faster pace. A lender may also create a payment structure whereby the customer makes a payment at a higher-than-normal amount at the beginning of a contract.

Time to refinance?

Over the last two years, customer borrowing costs have dropped significantly. For example, in June 2000, the 60-month U.S. Treasury rate was in the 6.3% range. Today, that same rate is about 3.5%. This is a good reason for a company to refinance, but there are several other reasons as well. Consolidating existing transactions. Some companies are current on their existing obligations, but simply want a reduced payment to better match their cash flows. Many times they don't anticipate the same level of cash flow because they have lost contracts or have been required to reduce prices.

Cash flow/planning for expansion. To facilitate growth, some companies refinance to boost their cash flow. They may also refinance equipment they own free and clear to access funds above and beyond the usual line-of-credit borrowings. Lenders will consider creating a sale/leaseback on equipment provided that the collateral value covers the request and the company has a strong plan and justification for the expansion.

Making past-due leases or loans current. Delinquencies have increased as the manufacturing sector has suffered through this economic downturn. Many businesses, therefore, can't meet their obligations. If this happens, a company may look to either the same lender or a different one to refinance its debt. Often, lenders extend the remaining term to drive the monthly obligation down to a manageable number based on what the company can handle. One critical element from a lender's point of view is to evaluate whether it's likely the company will survive the current problems and that the collateral involved has a liquidation value that will cover the transaction risk. It should be noted that a lender is not likely to "step into" a problem loan from another financial institution unless it is well collateralized and compensated for that risk.