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How do I qualify borrowers as historical data gets worse instead of better?

Your question:

I have heard you say that business lending will be harder in the recovery, not easier. What is going to make it harder and what specific additional steps do lenders need to take to get the borrowers qualified?

Linda says:

Here is the challenge…as we move into the recovery you are still using historical data to project recurring cashflow available to pay debt. But as time moves on, the newer year’s history is going to be from the worst of the recession and you are dropping off the older year’s which were before the recession.
 
Perhaps you have been using 2005, 2006 and 2007. When you can get the extended 2008 returns, you’ll drop off 2005. Even worse, if you only use two year’s tax returns, you are dropping off 2005 and 2006 and you are left with 2007 and 2008.
 
Many businesses had some rough years starting in 2007 and certainly going through 2008. By the time you get their 2009 year-to-date financials it may not be a pretty picture.

And it may not be a very accurate picture of how their business will do as the economy improves. You are losing the historical evidence of profitability just when the business borrower needs to gear up for the recovery and borrow more.

Here are some specific suggestions…

The first suggestions are at the level of lending guidelines. If you are not operating at the guidelines level, forward this link to the person in your bank or credit union who is.

Guideline level suggestions:

  1. Increase the number of years you review. If it has been two year’s returns, consider three. If three, consider four. This allows the pre-recession numbers to stay in the analysis.
  2. Allow lender’s to include year-to-date financial statement information in the analysis
    1. This may require CPA-prepared instead of borrower-prepared statements. Or even CPA-reviewed instead of CPA-compiled.
    2. The lender must have confidence that the financial statements seem reasonable. Comparing them to pre-recession statements may be helpful.
    3. The lender must be able to adjust accrual-basis financial statements to cash-basis if the tax returns are cash-basis to get comparable numbers.
    4. If you prefer the lender not actually include the year-to-date numbers in the averages, at least require they analyze the year-to-date information and include their conclusions in the write-up.

The challenge with guidelines:
While lending management may have great ideas to improve the flexibility necessary to make good loan decisions in the recovery, by which I mean saying ‘yes’ to loans that will be performing, the limiting factor will be the regulators.

While regulators may have great ideas to improve the flexibility necessary to make good loan decisions in the recovery, individual regulators do not have that authority.

We are a bit stuck until regulators get guidance that allows for more flexibility.

Lenders are in the front lines:
As usual, the lenders are the first step in saying ‘yes’. Regardless of your guidelines and the pressure of the regulators, your job is to find and make good loans. As the guidelines and the guidance from the regulators evolves, continue to ask the questions:

  • Will they pay if they can?
    • Character (Would you be comfortable with a handshake on the deal?)
    • Capital (Do they have skin in the game? May need to look at global including owner/guarantors instead of just the business capital)
  • Does it look like they can?
    • Capacity (Cashflow, management)
    • Coverage (Insurance, breadth of management)
    • Conditions (Economic, local, industry)
  • What if they can’t?
    • Collateral
    • Owner Guarantee (Income, Liquidity)

Let me know how your guidelines are changing, or how you think they perhaps should change, to accommodate the tougher lending conditions as the recession recedes.

About the Author
Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis. She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.