COMMERCIAL LENDING 101 - Part I

Commercial Lending 101 - Part 1
by Bob G. Hayes

When contemplating expansion of the Commercial Lending Arena or entering this exciting financial product, there are some things that need full understanding.

Have you or your designated lenders had Financial Statement Analysis training?
Have you established the Lending Philosophy that fits your Bank, your market, your future goals, the Board of Directors, Management and the Lending Staff?
Are you comfortable with the abilities of the Senior Lending Staff to properly implement, and safe-guard, your chosen Lending Philosophy?
Have you established one-year, two-year and five-year goals through Strategic Planning?

We must remember the credit disasters of the 1980's. We have just emerged from a economic growth period of approximately eight years in length. During this time, history began to repeat itself with highly competitive environments that bordered on overly aggressive lending through the desire to expand market share and allow other financial institutions to dictate internal lending policies. This is not to say that aggressive lending will be the cause of problems for your institution, but proper controls must be in place with one eye on the past mistakes and the other eye on the future benefits. We'll discuss this type of lending later in this paper.

In looking at the 1980's, it was discouraging that problem assets seemed to be concentrated in the larger institutions. These institutions had the ability to have the best policies, procedures, internal controls, and the most highly skilled lenders. In some cases, those "highly skilled lenders" deviated from the "basics" of lending. Instead, trying to impress others, they reverted to "sophisticated thinking" that gets a lot of Bankers in trouble. Regardless of the complexity of a credit, the basics apply in all cases. "Cash Pays Debt". How we arrive at that assumption is mute as long as it is factual, supported, and is sustainable.

Let's talk about the "Basics".

Character - how the business and the principals view their previous credit obligations. Have they paid as agreed? Are they interested in the success of the company? How do you feel about their management ability? Is it sufficient for their present size and do you feel they have the ability to manage as the business grows?

Capacity - the ability of the company to pay debt (not just yours but others according to their plan for the future). Normally, capacity to service debt is figured by the sum of net profits (after tax), depreciation and interest expense, unless the use of Accounts Receivable is necessary in the conduct of their business, then more involved calculations are necessary. Be sure that "total debt" is to be considered if there is debt outside yours. A shock test (rates that would be applicable in an up-market) should be applied to determine the ability to pay debt in an up-market. The amount of Shock to be applied would be determined on the rate structure applied to the credit, i.e., Prime plus 1% floating (daily, monthly, quarterly or annually). Capacity can also be referred to as the "Primary Source of Repayment".

Collateral - this is considered a "back door" in those cases when unforeseen problems arise that would diminish the ability to repay debt. Always consider the economic situation that could arise during the duration of the loan. Economic conditions can change that may affect the collateral value. Also, if the collateral is to be the "back door" for our safeguard, we should know, without a shadow of doubt, the value of the collateral at the time the loan is generated, plus we should know, during the duration of the loan, the continuing value. The type of collateral that we use as security can be labor intensive, and risky. That means that we should check the collateral position quite often. This drives the cost of the credit upward and should be taken into consideration when pricing that credit, coupled with the other strengths, or weaknesses of the credit. Not to be forgotten, is the present or future relationship that this credit will enhance. Collateral can also be referred to as the "Secondary Source of Repayment".

Capital - the ability to sustain a downturn in the economy. Also, establishes a commitment of the owner to his business. Low capital position raises questions, even though capacity is sufficient, whether the owner is "bleeding" the company for personal gain, or there could be a downward trend in the business being operated. However, the reverse could be true if the Corporation is a "sub-chapter S", but the questions raised should be answered to the satisfaction of the credit culture.

Conditions - economic conditions, industry, geographic dependence. The economic conditions prevalent at the time the credit is initiated is only part of the task to determine the viability of the credit. What are the terms of the credit? What will the economy look like during the duration of the credit? It is very difficult to foresee problems, however, if the economy is strong, remember there will be a down-turn. Maybe not during the life of the credit(s), but it will eventually happen. Is the Industry that you are dealing with of a volatile nature? Will a down-turn put pressure on their industry type? There are industry types that will be affected more than others when economic conditions decline and consumer confidence drops. Geographic dependence is a factor that should be considered, for instance, computer software companies, the oil industry, agriculture, to mention just a few. Another example would be Commercial Real Estate. During the 1980's, this industry was hit extremely hard, especially in the East, West and deep South. Those dependant upon third party lease income should be looked at very hard. Certainly the maker of the note should have expertise in this area, along with the ability to service the debt if the third party lessee should falter. Strong consideration should be give to the collateral value and the equity position that the maker will assume. Along with this, the type of equity assumed by the maker should be a factor in the final decision.

The five "C's" of lending should never be thought of as "old fashioned". Those that do, find themselves searching for that perfect tool to assist them in analyzing credits. This tried and true method, if applied with diligence, will cause us as Bankers to be aware of the pitfalls of every credit that we lay our hands on. In turn, when we diligently apply these "C's", we can devise the credit culture that will be most beneficial to the Bank and it's future.

?2002 Strategic Advantage, Inc.

Bob G Hayes, Asset Quality Analyst of Strategic Advantage, has over 40 years of banking and lending experience. For more information call, (405) 641-6748, e-mail: bhayes4444@msn.com.

First published on BankersOnline.com 3/18/02