How to Screw Up Your Bank Loan

This week, we have another guest blooger - Mike Otto, VP Lending, John Marshall Bank, 571-405-2919 (o) motto@johnmarshallbank.com

Mike was answering a question from a potential borrower about how the bank evaluates a business loan application. Mike's answer shows how a business owner can screw himself / herself by reporting a really low income to the IRS and then trying to get a bank loan. Here are Mike's comments:
*****************************************************************
In looking at the historical cash flow of a business, banks (all banks) look at tax returns and CPA prepared year end financials to confirm that the company prepared numbers which are available throughout the year are an accurate snapshot of the businesses performance. Some banks (like us) also look at the "global" cash flow of the business and borrower - taking into account the financial wherewithal of the guarantor in addition to the business cash flow.

The financial meltdown we saw has hurt businesses in more ways than they realize. The natural tendency of most business owners is to try to minimize their tax exposure where they can, and when they are doing well, this is ideal. The problem occurs when they need to either borrow money… or sell their business. Banks are under an extreme amount of scrutiny on who they lend to and why they are making certain loans… we have to justify to examiners our calculations and why we make the loans that we do to our clients… Yes, I know that President Obama is telling the American Public that banks need to lend more to small businesses and loosen up lending standards; however, the reality is that Federal Examiners - due to those bank failures we all saw - are scrutinizing everything we do, more now than ever before. Every loan that a bank makes is subject to review by examiners; they review only a small percentage of our loans, but they can ask to see them all… if need be. If a "potentially" bad loan is found on their review… or a calculation cannot be explained… or if the examiners feel the bank's lending guidelines are too relaxed (lenient), then they can widen their review and ask for more files, and more files, and more files… until they are comfortable with a bank's ability to lend, or deem them unfit and put them on the "potentially" troubled bank list, which becomes public knowledge. The net effect is that banks are discouraged from lending money in this environment - which is why most big banks have slowed down or stopped lending altogether and have focused their resources on cleaning up their existing loan portfolio.

I guess in summary, as a bank lending overview - banks look at business cash flow (historical as well as projected) to determine the Debt Service Coverage Ratio (DSCR) - these tell the bank how many times the business can cover the proposed new debt (1.25x to 1.50x or greater is what the bank would like to see in the current environment), and how much extra cash is available in case of an unexpected "challenge" in the business; this is considered the "primary" source of repayment of the debt. In addition to this, banks look at a "secondary" source of repayment, just in case the business is not able to cover the debt through that primary repayment source - as they have projected; the guarantor's net worth and liquid assets come into play here (the global cash flow I mentioned earlier). In addition to that, banks will also look at collateral to cover the loan in case of a meltdown; overkill at times, I know, but banks are conservative and are lending stockholders money - not investing in a business, so they have to be conservative. These things, as well as past credit performance/history, are a large part of what the bank looks at with any credit request, and why we are careful to be able to confirm/justify all our calculations. The bank needs to be able to justify that the cash flow of the business is sufficient for the business to support its existing debts and any additional debts they incur.
*****************************************************************
Thanks Mike! Great advice to loan seekers in this economy.