Taking the mystery out of

commercial loan underwriting

Commercial lending differs from most

consumer lending, such as residential
mortgage lending, in that there are no
hard rules or ratios that make a loan
either acceptable or unacceptable.
Commercial lending is a bit more
of an art than a science. However,
the underwriting process of sound
commercial lending is not the mystery
it may seem to be. It is simply a process
of information gathering (or due
diligence), financial analysis, and the
making of informed judgements. The
process described in this article would
be typical for a new client, with a more
streamlined process for an existing
client that a bank already knows well.
While the process described may seem
rigorous, remember that banks operate
on very thin margins. Net interest
income margins are typically around
4%, as compared to a corresponding
gross profit margin for most businesses
of anywhere between 15% and 50%.
This, coupled with the fact that banks
are highly regulated and are lending
depositor and shareholder money,
makes it clear that there is little room
for write offs of bad loans. That is why
there are typically several potential
sources of repayment for a commercial
loan cash flow, collateral, and
guarantors.
To analyze these repayment sources,
the bank must first get to know and
understand the prospective borrower.
The due diligence process begins by

meeting with company management.

General information is gathered for
an understanding of the business
discussion regarding ownership,
management, products and markets,
financial information, and brochures on
the company. This provides necessary
background information, and gives the
lender an impression of managements
understanding of the business. Does
management understand the companys
financial statements, competition,
competitive advantages, etc.?
The financial information typically
collected includes year end balance
sheets
and
income
statements
for the past three years, the most
recent interim financials along with
corresponding statements from the
prior year, the annual budget, business
tax returns (if year end statements are
unaudited), accounts receivable aging,
and possibly accounts payable aging.
In addition, for most privately held
businesses, the owner(s) guarantee
the debt, so current personal financial
statements and personal tax returns
are collected. All of this information will
be used later by the lender as part of
the financial analysis.
Ideally, at least one meeting will be
held at the business location so a tour
of the facilities can be conducted.
This will allow for observation of
the general working environment,
equipment quality and upkeep, and
inventory control and management.

Furthermore it provides an insight into

managements understanding of the
operations.
The due diligence continues as the
lender, if unfamiliar with the industry,
does general industry research as well
as investigating trends or changes
affecting the industry and specific
threats to the prospective customer.
This investigation may also include
contacting any significant customers or
vendors of the business.
In addition, information will be garnered
from outside credit sources such as Dun
& Bradstreet for the business and credit
bureau reports on guarantors to learn
of any historical payment problems.
Uniform Commercial Code searches
are also done to determine if other
creditors hold superior lien positions.
If positive results are obtained, a
written analysis is done by the loan
officer using the information gathered.
This is the analysis that will be reviewed
by the loan committee or used to
document the lenders individual loan
approval. The basic part of this written
analysis would include sections on the

YOUR SUCCESS COMES FIRST.

history of the business, management,

products and markets, loan purpose,
financial analysis of the business,
collateral analysis, and financial analysis
of any guarantors. The goal of this
analysis is to reasonably assess the
likelihood of continued future success
for the company.
The history of the business gives an idea
of the companys evolution, historical
success and longevity. In addition, the
type of ownership (sole proprietorship,
S Corp., LLC, etc.) will shed light on
what financial information needs to be
examined and how the loan should be
structured and possibly guaranteed.
The management assessment will
include not only the owners but
also other key personnel. Relevant
information will include individuals
names, areas of responsibility, tenure
with the company, and prior experience.
The goal is to not only determine
managements experience level, but
also its depth. In some businesses, there
is a large reliance on a key individual,
and this risk needs to be addressed,
possibly with life insurance on the key
person.
The companys product and market
should also be well understood. What
exactly do they do? The analysis
should articulate how they differentiate
themselves from their competitors.
Is the company positioned as a low
cost provider or do they provide
higher quality, better service, or

faster turnaround? Who are the major

competitors and what are barriers to
entry for new competitors? Who are
major customers and industries sold
to, and is there a major concentration
risk to be analyzed? How are sales
generated - by inside sales people,
outside sales reps, or distributors?
Are revenues cyclical with the general
economy and/or seasonal? This should
be considered when structuring loans
and loan payment requirements. All
of these types of questions need to
be answered, thought through, and
analyzed, to identify areas of potential
market risk.
The purpose of the loan needs to be
considered, so the appropriate credit
structure is used. For example, working
capital needs caused by growth should
be funded by a line of credit with
interest only payments required, while
an amortizing term loan better matches
the life of longer term assets such as
equipment or real estate. Also, a brief
schedule of the sources and uses of the
transaction may clarify the credit need.
A significant part of the analysis is
based on the financial statements.
Banks use industry specific spreadsheet
software to analyze these statements,
looking at several periods for trends
and significant changes as well as
generating various financial ratios
for analysis. While this analysis can
be in depth, a few key pieces of data
are fundamental. For example, major
items on the balance sheet that are

examined include: liquidity, the ability

to meet current obligations, using the
current ratio (current assets divided by
current liabilities) or working capital
(current assets minus current liabilities);
and leverage, the companys net worth
position relative to its liabilities, using
a debt-to-worth ratio (total liabilities
divided by net worth). An acceptable
current ratio or debt-to-worth ratio
depends on the industry and the life
cycle of the company. For example, is
it a relatively young company, a recent
acquisition, or a fast growing business?
Consequently, these types of ratios are
looked at for trends and are measured
against industry norms (banks typically
use Robert Morris & Associates data).
Similarly, days outstanding of accounts
receivable, inventory and accounts
payable are measured versus industry
norms and previous period levels.
Large variances can indicate problems
with collections, inventory controls
and/or cash flow, which would need
further explanation.
The income statement is analyzed to
look at items beyond just sales and
net income growth or compression.
For example, gross profit margins
and operating expense levels are
compared to industry averages and
examined for trends. Management
needs to have plausible explanations
for changes to these items relative to
business strategies e.g. sales are up but
gross profit margin is down and sales
expenses are up due to penetration
into a new geographic market, or

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YOUR SUCCESS COMES FIRST.

economic and market conditions e.g.
raw materials costs rose and it took
time to work through the pricing in
contracts already in place.
Cash flow is the primary source of
debt repayment and paramount in
importance in most loan situations.
Cash flow is different from earnings, in
that noncash items such as depreciation
from the income statement, balance
sheet changes such as growing
receivables and inventory levels,
and other debt payments need to
be factored in. The banks software
calculates cash flow using both the
income statement results and balance
sheet changes and is used in this
analysis. The lender analyzes historical,
current and projected ability to service
the debt as well as capital expenditure
needs and any other obligations which
must be paid.
Collateral analysis is a basic part of
any loan analysis, in that it provides a

secondary source of repayment should

the expected future cash flow not come
to fruition. The bank will look at the
values of the companys assets on which
it has a lien, and apply a discounted
value for collateral purposes. The bank
would usually not lend beyond that
amount unless there would be a strong
guarantor or other collateral. Beyond
experience and industry standards for
discount factors, appraisals can be done
for both real estate and equipment to
aid in this analysis.
Finally, the financial statements of
any guarantors need to be analyzed
to see what additional strength the
guarantors bring to the deal. Beyond
the guarantors net worth, personal
liquidity is the key. Cash or marketable
securities provide liquidity to cover
temporary cash flow shortages, or can
be a secondary source of repayment
on unsecured or under-collateralized
loans. Analysis is also often completed
on the guarantors personal cash flow,

which goes beyond just personal

income, factoring in other items such
as required personal debt service.
In the end, a conclusion needs to
be drawn and a decision made. The
science is in the process outlined
above. Now the art of the judgement
of all these factors is performed and a
final approval or denial is made. There
is rarely a clear cut situation. Even
for a strong company, there may be
a question mark about the business
longevity,
management
depth,
competitive threats, a concentration
with one customer, or issues on the
financial statements. These pluses and
minuses are weighed and a decision
is made. In the end, this is where the
lender and the loan committee prove
their worth and provide well structured
and prudent loans to their community.

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