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Loan underwriting is the process the lender goes through to decide whether to approve a loan lenders

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use the five C's of credit when deciding whether to make a loan.

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The first and most important is character.

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I like to use the word credibility for this.

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It includes your business reputation education professional credentials and personal integrity.

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You may need to provide references for the lender to check all financial transactions are built on trust.

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Find ways in the application materials to prove why the lender can trust you to be a good business partner

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and pay back the funds.

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How you treat the bank staff and I mean all the bank staff not just the business officer matters.

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When I worked at community banks we were willing to fire customers that disrespected tellers both borrower

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and lender when with a good relationship here's a link to a good article in U.S. News and World Report

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on the five C's of credit.

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I was a source for the article and talking about the importance of character and credibility capacity

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is your ability to pay back the loan.

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Profits are nice but lenders underwrite on cashflow.

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I'll show you their main metric for this on the next slide.

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A credit analyst will take your tax returns or financial statements and do what's called a financial

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statement spread.

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It's basically putting your financials or tax forms in Excel to do financial analysis capital analysis

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make sure you are invested in the business or its assets enough to protect the bank a very important

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ratio for measuring this is the loan to value ratio which I'll discuss in a later slide.

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Debt to equity ratios determine whether you've over leveraged meaning you have too much debt.

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Expect to be required to make a down payment of 20 to 25 percent for commercial real estate loans conditions

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referred to the financial health of you your company your industry and the economy and owner's personal

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financial woes suck the health out of their company.

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Conversely a financially strong owner is a source of strength for the company.

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Lenders are more willing to lend when an industry or economy is financially strong finally.

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Collateral is the quality of the assets you pledge for repayment.

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This may be less important than you may think for bank loans.

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I talked earlier about how hard money lenders underwrite their loans based on the collateral and less

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on repayment ability.

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Banks lend tight spreads to their cost of funds and high loan to values on assets.

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Any hiccup in loan repayment can cause a profitable loan to become unprofitable.

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That's why I listed the other sees with credit higher than collateral your collateral is only important

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to a lender when you can't pay them back from cashflow.

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There is a sixth see that I didn't put on the slide that has more to do with your lender than you.

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It's the lenders loan concentrations.

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Diversification in a bank's loan portfolio reduces risk just like a diverse set of investments reduces

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the risk of a personal investment portfolio.

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Banks have concentration limits in their credit policies.

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These limits promote geographic industry or collateral diversification when lenders are nearing a limit

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they will allocate their scarce capacity only to the strongest borrowers.

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For example if a bank has already made a lot of loans on storage units they may be more picky on storage

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unit loans going forward since they already have a lot of capital at risk to that industry.

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In that case the lender should give decent borrowers the it's not you it's me speech when declining

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alone.

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Those borrowers have a good chance of being funded by another lender.

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The big question a loan officer has to answer is how will the borrower pay back the loan.

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The Better Business can show this to the lender the better the odds the business will get the loan.

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The answer is providing multiple sources of repayment.

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The number and strength of sources of repayment reduces risk.

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Bankers are by nature cautious lenders.

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If they aren't that way naturally the banks credit committee and regulators will pounded into them loan

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proposals and analysis that loan officers prepare literally list the primary secondary and tertiary

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or third source of repayment.

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For example the primary source of repayment for commercial real estate loan is the business's operations.

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The secondary sources the sale of the building and the tertiary sources the guarantor other assets the

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cross collateralized loan the debt service coverage ratio is a type of debt to income ratio that's used

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for business loans.

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It's calculated as income divided by debt payments.

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The income number used is EBITDA which is earnings before interest tax depreciation and amortization.

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Another way to think about it is net operational cash flow.

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Less debt.

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Cash outflows.

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Lenders will calculate it based on the business's financials but will also compute the global debt service

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coverage ratio who combines the business financials with the owners financials the global DSR gets back

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to the concept of the last slide that the owners financial health can be a strength or a liability to

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the company.

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At the banks I worked at.

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Lenders were looking for a ratio of one point to five or higher which is consistent with industry norms

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a ratio of 1 means Ebola equals debt service the minimum ratio of one point to five adds a point to

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five or 25 percent cushion.

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Remember what I explained why Amr ization terms are longer than balloon terms.

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Long amortization terms reduce periodic debt service payments which improves this ratio a borrower might

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be well below a one point two five DSR with a 10 year Amitai ization term but well above it with a 25

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year amortization terms.

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In other words longer amortization allow more borrowers to qualify for larger business loans the debt

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service coverage ratio measures your cash flow and ability to pay when lenders assess the risk of their

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loan portfolio.

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They break losses into two components the probability of default and the severity of default.

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This ratio measures the probability of default which is how likely the borrow will be to not be able

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to meet the contractual debt service obligations a second import ratio is the loan to value it's calculated

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as the loan principal divided by the value of the collateral.

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It's mostly used for real estate.

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It may also be used for equipment.

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Earlier I talked about how lenders may require an appraisal as part of the loan underwriting process.

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The appraisal provides solid data for the denominator of this underwriting ratio.

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Banks require owners to have equity in their business and assets partly to reduce the loss on liquidation

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of the asset but also because owners take huge risks when they have nothing to lose.

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For real estate lenders will limit the LTV of a loan to 75 to 80 percent which means the borrower will

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make a 20 to 25 percent downpayment.

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I talked about hard money lenders earlier.

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They may limit LTV to 50 to 75 percent to reduce the high risk of their loans this ratio measures the

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severity of loss which is also called the loss given default.

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The previous ratio measured the probability of loss in this ratio measures how big the loss may be if

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the borrower does default.

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Loan covenants are ongoing requirements of the borrower during the life of the loan.

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They are listed in the loan agreement.

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They may include maintaining certain levels of debt ratios and other financial ratios like your current

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ratio the available balance on a line of credit is determined by the borrowing base.

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The borrowing base as a percentage of receivables or inventory whichever is collateralized in the line

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that determines the available credit on the line.

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This is measured and reported on a borrowing base certificate so both draws on lines and large decreases

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in the borrowing base reduce the available credit on a line the loan agreement may require you to get

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approval from the lender before you take on more debt.

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The loan agreement or security agreement may require you to keep the collateral insured the lender may

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require personal guarantees on business loans a guarantor is a person who pledges to pay back the loan.

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If the borrower can't or won't pay it back the lender often has the right to require payment from a

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guarantor even if the borrower hasn't defaulted.

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For example the lender may be concerned about the future repayment ability and ability of the borrower.

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So they approached the guarantor for payment sooner rather than later.

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This is rare but they do have that right.

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Lenders require personal guarantees from newer weaker companies personal guarantees are a big deal for

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business owners.

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If given the choice borrowers often choose lenders don't require personal guarantees.

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Many owners set up their companies with business entity selections that limit personal liability like

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LLC use or corporations.

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They then try to get debt for the company and have to put their personal assets at risk to get that

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debt.

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It's a risk that's too much for some owners the bank will measure the financial strength of the guarantor

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via financial ratios and the guarantors credit score.

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I talked earlier about how using credit cards can burn owners later owners who trash their credit score

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and personal credit cards won't be a strong enough guarantor for their company's business debt.

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Another caution is that guarantors have joint and several liability.

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Any guarantor can be required to repay the full amount of the loan.

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Some collectors will collect on all guarantors and some will just pick the most likely guarantor to

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pay and focus their collection efforts on that guarantor.

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If you guarantee a loan and are much stronger financially than the other guarantors you may receive

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more attention from the lenders collector who will let you work out a deal with the other guarantors

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rather than the collector trying to broker a deal with everyone how common are personal guarantees.

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Almost 60 percent of small businesses are required to provide a personal guarantee for their loans.

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It's also interesting to note that half of small businesses use business assets for collateral while

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almost a third pledge personal assets.