SECTION 3: TIPS FOR LENDERS

 
Tips - Presenting P2 Projects to Lenders

The decision regarding which alternative type of debt instrument to use to finance a company's P2 projects will be dependent upon the liquid cash position of a company and the decision of a management team to build the asset side of the balance sheet. All scenarios could be candidates for term debt instruments or leases. Leases are debt instruments that allow a company to purchase the full amount of an item without a down payment. The interest rate is typically higher, as well as the monthly payments. However, there is not as much interest paid throughout the life of a lease. At the end of the lease period the equipment is returned to the leasing company. Leases do not allow companies to add the asset to their balance sheet.

Term debt is where the full amount of a loan is dispersed at one time. The total amount of the loan is then paid back over time. There are different types of term debts available to borrowers. Conventional banking and non-banking lending institutions make term loans, which can be made directly by them or can be enhanced by a Small Business Administration (SBA) guarantee.

Lending institutions will not lend 100% of the purchase price of the P2 equipment. In addition, they do not make equipment loans for longer than five years. To get a longer term maturity, a business can ask for an SBA guarantee, which will also provide a capped rate of interest on the guaranteed portion of the loan.

The SBA has two lending programs that may be utilized for equipment purchases. The first program, SBA 7 A , permits it to guarantee up to 75% of the full amount of a loan provided by a private lending institution. Secondly, the SBA 504 loan program will lend up to 40% of the total loan. Relative to conventional financing, the 40% of the loan proceeds provided through the SBA 504 program, will carry a fixed interest rate for a longer term, and does not require that a specific amount of jobs be created.

The first thing to keep in mind when you consider approaching a lending institution for a loan is that a lenders rules for making a loan are driven by what the sources of repayment will be to support an outstanding loan. A primary rule of thumb, which every lender is taught, is to identify what three specific sources of revenue the company will have to repay the loan. The first source of repayment, the Primary Source of repayment, will be the operational cash flows of the business. The secondary source of repayment will be from the liquidation of collateral (the assets) to repay the debt. The third source of repayment will be from the company owner's personal financial strength. Companies with a strong financial position will be able to prove the primary and secondary sources of repayment without a problem. A startup company or relatively new company, without a proven historical track record, will be considered primarily based on the owner's personal financial strength. The company's projected cash flows will be taken into consideration but will not be the determining factor in making the loan.

To increase the success rate of acquiring a loan for your company the borrower should be prepared to produce the following documents for a lender to review.

1. A concise business plan.
2. A complete set of the company's historical financial information for the last three years, which will include the following:

• Balance Sheet;
• Income statement;
• Cash flow statement;
• Most current interim statement no older than 90 days.

3. Complete sets of the company's tax returns for the past three years.

The four points mentioned above are the minimum amounts of information that the lender will need to review. In reviewing your company's information the lender will go through a qualifying process. The qualifying process will include the calculation of various ratios, examining historical cash flows, projected cash flows, information about management, information concerning your industry and your position in the industry. After reviewing these factors, the lending institution, will determine the level of risk it is willing to take in consideration of the repayment of your debt.

In most instances, the lending institution will require a low level of risk to the point where repayment is almost totally guaranteed.

To understand the process of a loan application, let us look at what steps a lender will go through to determine the feasibility of your loan application.

The lender will first look at your Income Statement, also known as a Profit and Loss Statement, to determine if there is sufficient cash flow to repay the debt. The first ratio they will use is a ratio called the debt cash coverage ratio. Debt Cash Coverage = (net profits plus non-cash items) divided by annualized debt payments for one year. The ratio must calculate out to be 1.2 or higher. This will determine that the company will have sufficient cash flow to repay debt.

The second ratio used will be the current ratio = current assets/current liabilities. This is also known as a solvency ratio. This ratio calculates the current assets that will convert to cash in one year and divides that number by the liabilities that must be paid within a year. If the ratio calculates below 1, then the lender will determine that they will not be able to convert enough current assets to cash in order to repay short-term debt.

To understand how the ratios are calculated let us look at some examples.

Debt Cash Coverage = Adjusted Net Profit divided by annualized debt payments.

Let's say your company would like to purchase a $50,000 piece of equipment and use a term loan to finance your purchase. The bank will not lend you 100% of the purchase price of the loan but will lend you $40,000. The following scenario could occur:

Loan amount: $40,000

*Interest rate: 9.25% Principal and Interest

Term of Loan: 10 years

Monthly loan payment: $512.13

Annual loan payment: $6,145.57

You now have half of the equation. The next thing you will do is go to the net profit of your income statement. The ratio considers that net profit will be adjusted for your calculation. What this means is that assuming that your income statement is based on an accrual basis not a cash basis, you will add back in items such as accumulated depreciation and interest to the net profit number to get a number that is more representative of your company's cash flow. For example your income statement may look like this:

Annual Sales: $500,000

Cost of Goods Sold: $300,000

Gross Profit Margin: $200,000

Expenses: $ 90,000

Net Profit: $110,000

You now know the two critical factors for you to do your debt cash coverage ratio calculation.

Net Profit = $110,000

Annual loan payment = $ 6,146 = 17.89

The minimum requirement of the ratio is not to go below 1.2 so now you know that your numbers show that you have sufficient cash flow to pay this debt, assuming that your company has no other debt payments.

Liquidity, as stated above, can be measured in part by the current ratio. The information for this ratio is based on all information from your company's balance sheet. The ratio calculates all the current assets, (those assets that will liquidate within one year's period of time) divided by all current liabilities, (those liabilities that must be paid within one year's period of time.) Let's say that your balance sheet will have the following composite:

Assets

Cash: $ 27, 464.50
Accounts Receivable
Inventory
Total Current Assets: $ 27,464.50
Equipment: $122,578.46
Furniture and Fixtures: $ 16,091.15
Other Assets: $ 4,380.50
Patent: $ 6,144.00
Investments: $ 14,000.00
Total Assets: $ 190,658.16

Liabilities

Accounts Payable
Accruals: $1,332.94
Current Maturity of Long term Debt
Revolving line of credit
Total Current Liabilities: $ 1,332.94
Long Term Debt: $ 34,519.29
Total Liabilities: $ 35,852.23
Owners Equity
Equity: $154,805.93

Total Liabilities & Net Worth $ 190,658.16

To calculate the current ratio using the sample balance sheet from above, we would do the following:

Current Assets = $27,464.50

Current Liabilities = $ 1,332.94 = 20.60: 1

A very healthy company.

Leverage is where a company and lender will determine how much debt the company can acquire before it will be adversely affected. The ratio used to help a company determine whether it is using debt to help the company or is becoming overburdened with debt is the debt to worth ratio. The ratio calculates to be Total Debt/Total Net Worth, which is the total debt of the company from the balance sheet, divided by the total amount of equity, (stock, paid-in-capital, retained earnings). If the ratio calculates too high such 5:1, the company will be considered to have a debt overburden (too leveraged) which will create difficulty in generating enough operational cash flow to repay the debt.

Example:

Let's use the example from the balance sheet already listed above. To see if the company is leveraged we would calculate:

Total Debt = $ 35,852.23

Total Net Worth = $ 154,805.93 = .23:1

Remember a ratio of 1:1 is average .23:1 signifies a very healthy company that is not leveraged. Debt to Net Worth would change adding the $40,000 term loan. The ratio would then calculate as follows:

Total Debt = $ 75, 852.23

Total Net Worth = $ 154,805.93 =.49:1

This is still less than a 1:1 ratio but the leverage is increasing.

After it has been determined that there is enough cash flow for repayment the lender will then look at your balance sheet to see if there is sufficient collateral to support the amount of the loan for the second source of repayment. Collateral is taken by the lender as security for your loan for a couple of reasons. The first is if you do not have a strong historical financial cash flow that will sufficiently support the loan payments. The collateral will be taken as an insurance policy, that if you default on the loan, the collateral can be liquidated and the loan is repaid. Even if a company can prove that their cash flow has been strong and will continue to be strong, lending institutions will take the collateral as an abundance of caution. This is due to the rule of lending set down by the agencies that regulate banking institutions. Once the loan has been established and the payments have been made on a consistent basis, the lender and borrower can negotiate to release certain portions of collateral.

From our example balance sheet we see the following assets that can be used to secure a loan.

Bank Asset

Balance Sheet Loan Ratio* Asset Loan Value

Equipment $122,578.46 60% $ 73,547.07

Furniture & Assets $ 16,091.15 25% $ 4,022.78

Patent $ 6,144.00 20% $ 1,228.80

Investments $ 14,000.00 90% $ 12,600.00

Total $ 158,813.61 $ 91,398.65

*The type of asset that you have to pledge will determine the value that an asset has available to help secure the loan.

In our discussion above we determined that the company would want to purchase a $50,000 piece of machinery. The total asset loan value of $91,398.65 is more than sufficient to cover the loan value. The bank would be willing to loan $40,000 on the equipment. The bank would do the following:

1. Put a lien on the new equipment for the cost of the equipment $ 50,000.
2. The lending institution would then look at the remaining assets to see what additional assets could be pledged over the amount of the loan as an "abundance of caution." This is also in addition to proving that you have existing cash flow from your income statement to pay the new debt.
3. Once you have determined that you are paying your debt in agreement to the terms of your note, you can negotiate with the lending institution to decrease the amount of collateral you will need to secure the loan.

The third source of repayment for a loan, personal guarantees, will require that persons owning twenty percent or more of a company, will be looked to, to help support repayment of the companies debt. Personal guarantees will be necessary dependent upon the credit quality of the company and the historical financial track record of the company.

Revolving lines of credit are like corporate credit cards for your company. The process in approving a loan for your company for this type of loan is the same as the term debt loan above. The most prominent difference is that this loan will require a closer look at the current assets such as accounts receivable, inventory and accounts payable to see how each account fluctuates. This will determine what amount will be needed for the line. The collateral would focus on those assets.

Leasing is essentially renting a fixed asset such as a computer, a copy machine or a large piece of machinery. There are various reasons why a business would lease rather than go into substantial debt. One reason is flexibility to structure a lease payment to meet the varied needs of your company. The flexibility of a lease will include allowing to compensate for irregular cash flows, limited investment capital for fixed assets, bank line restrictions or equipment obsolescence concerns. There are also tax advantages which will allow the company to deduct lease payments as a business expense rather than having to deal with depreciation schedules. A disadvantage to leasing is that, since the asset is not recorded on your balance sheet, you will not be able to build the assets of your company.

To graphically understand the benefits of leasing versus term financing let's go through the elements of a lease and traditional term financing.

Manufacturing Equipment: Lease versus Purchase of Equipment

60 month 60 month

Traditional Lease

Term Financing Financing

Purchase Price of Equipment $500,000 $500,000

Down Payment Required -100,000 -0-

Amount Financed $400,000 $500,000

Estimated Residual Value @ end of term -0- $100,000

Payments are Based on: $400,000 $500,000

Interest rate 10% 11%

Base Payment $ 8,429 $ 9,526

Sales Tax

(7.3% or Base Payment) -0- -0-

$ 8,429 $ 9,526

Sales Tax -0- -0-

Down Payment $ 100,000

First Payment in Advance $ 9,526

Total Cash Paid Up Front $ 100,000 $ 9,526

Total Cash Outlay Over Term $ 605,740 $571,560

The net effect of a lease on the company's financials would be as follows

Operating Lease None Rental Expense

Capital Lease Capital Lease Asset Depreciation

Capital Lease Obligation Interest Expense

Each of the three companies in the case studies that follow is eligible for conventional bank and non-bank financing, with or without an SBA guarantee, an SBA 504 program equipment loan, or leasing the equipment.