There are four different types of lenders:
- Schedule A: Canadian-owned ‘Big 6’ banks (RBC, TD, Scotiabank, BMO, CIBC, and the National Bank of Canada)
- Schedule B: Financial institutions (e.g., trust companies and credit unions) that offer loans to borrowers who don’t qualify for traditional “A” lender loans
- Alternative: Non-bank financial institutions or private companies that operate outside the conventional banking system and often have less strict criteria but may charge higher interest rates to compensate for increased risk
- Private: Friends and family
Banks are more likely to lend because they’re in the first position of an insolvency while secondary lenders may not get their money back. Loans from alternative lenders should be used as bridge financing or an interim solution before getting credit from a schedule A lender.
Looking for a new lender?
As part of the assessment in granting a new loan, lenders often consider a variety of factors including:
- Understanding your business: First, the lender will want to understand the nature of your business. Have you prepared a well-thought-out and researched business plan to support your request for financing? Borrowers should be prepared to provide the lender with a summary of the long-term strategy and a true depiction of the positive and negative issues affecting the business. There is likely no one who will understand the business and tell the story better than you. Lenders ultimately want to get an understanding of how the business operates as well as its strengths, weaknesses, opportunities, and threats.
- Governance: There are several factors to consider here including whether your business has effective oversight (such as a Board of Directors and other committees with a mix of internal and independent members) and whether it has documented and effective policies and procedures. Also, whether it engages in long-term strategic planning and whether you have a clear short-term business plan. When a business is lacking a strong governance structure, it’s a red flag for lenders.
- Organizational structure: Factors lenders look for here include the lines of authority, the nature of the individuals with decision making authority, the relationship between the owners and independent investors, and whether their ideas and interests align or are conflicting. Ultimately, the strength of your business’ management team will largely determine its ability to generate enough cash flow to repay the loan (i.e., can they successfully run the business and make money?).
- Financial health: The lender will assess the likelihood of your business being able to repay the loan and likely request historical and forward-looking financial information.
- Financial impact: How would the loan impact the company? Although asking for a larger loan seems like it could be a red flag for lenders, many businesses don’t obtain a large enough loan. Underestimating the amount of money that your business needs can lead to problems, such as a lack of working capital, sooner than planned. Most business plans should include a financial projection that demonstrates how the financing will be used, and if your company will comfortably be able to service the debt into the future.
- Plan for the money: What is your business’ strategic plan, or detailed road map? The strategic plan and budget should be clear and help the lender understand how the loan fits into the plan.
- Personal or corporate guarantees: Lenders will also consider the collateral and/or guarantees offered by the business as well as the personal financial situation of the owners. They often want to see that the business owners are willing to demonstrate their commitment to success—or as Warren Buffet would say, ‘do they have skin in the game?’ If a lender requires a guarantee, it’s recommended that you bring on a neutral third party to review your finances as well as help you make rationale (not emotional) decisions.
- The industry in which you operate: The industry in which you operate: Certain industries are considered higher risk, and lenders will adjust their level of scrutiny and diligence depending on the type of business. This is a practical reality of working with lenders, but one that can be mitigated in part with a strong strategic plan.
Although the lender will consider the “cold hard facts,” a lot of what they will consider is based on “feeling.” That’s why your business should start building a relationship with potential lenders before you need the loan.
Keeping your lender happy
For lenders to perform an effective analysis, they need to calculate certain ratios and compare your business’ results to its peers and/or industry benchmarks. These ratios reveal basic information, such as whether your business has accumulated too much debt, has stockpiled too much inventory, or is not collecting receivables quickly enough.
Lenders often include ongoing reporting requirements in loan agreements. In many cases, this means the borrower will be required to submit its financial statements to the lender on a regular basis. Financial statements are intended to tell the lender a story about the business, one that might be told without the lender ever meeting or speaking with the business’ management or owners.
Lenders generally focus their attention on three main components of financial statements including:
- The balance sheet offers the lender a snapshot of the business’ overall performance and reports the assets it owns and liabilities it owes at any given time.
- The income statement summarizes the business’ revenue and expenses, offering a side-by-side picture of these important numbers. It indicates whether the business is making money or losing money.
- The cash flow statement demonstrates how much cash flowed in and out of the business in a given period and how much cash is available to the business.
Evaluating performance
When reviewing a business’ financial statements, lenders will generally assess performance, liquidity, and leverage. A history of strong performance, combined with evidence of sound management practices and good financial controls provides assurance to a lender that the business is likely to continue successfully for the foreseeable future. To do this, the lender often looks at two types of ratios:
- Efficiency ratios, which are generally measured over a 3–5-year period and provide insight into areas such as collections, cash flow and operational results.
- Profitability ratios, which evaluate the financial viability of the enterprise.
These ratios tell the lender how well the business used the assets to generate profit and cash flows. By comparing current results to both historical trends and industry averages, the lender will be able to estimate the likelihood of continued success.
Assessing leverage
Another factor the lender will want to evaluate is the business’ leverage by assessing levels of debt as compared to its equity and assets in order to evaluate its ability to pay its debts. The two most common leverage ratios that a lender will consider are: debt-to-equity and debt to asset. These ratios are used by lenders to see how a business’ assets are financed, for example, whether the money comes from creditors or the business’ owners. In general, a lender will consider a lower ratio to be a good indicator of the business’ ability to repay its debts or take on additional debt to support new opportunities.
The value of benchmarking
It’s important to understand ratios on their own will have limited usefulness—it’s only once they’re compared to something that they gain meaning. For instance, perhaps a business experienced a downturn in its net profit margin of 10% over the pandemic, which may seem worrying. If its competitors experienced an average downturn of 20%, then the business is still seen as performing relatively well. This is why lenders compare the business’ ratios to those from prior periods and to current industry norms, which is commonly referred to as benchmarking.
If you take the time to calculate your business’ key ratios and perform benchmarking and trend analysis, you can identify and discuss any troublesome trends or explain significant deviations from your peers in advance of the lender doing their own analysis. Another benefit of doing this work on a regular basis is that it can help detect problems and run your businesses more effectively. For example, if your business is not turning over its receivables fast enough, it may have a cash flow problem. Once identified, that issue can be addressed by changing procedures or company culture to collect payments more proactively. Alternatively, if inventory is turning over too slowly, you may need to look at the product mix and either add something new or get rid of something old.
In summary, ratios shouldn’t be evaluated only when visiting your lender. Ideally, your business should review its ratios on a regular basis to keep on top of changing trends in the company.
Additional tips to keep your lender happy
- Establish a trusting relationship: One of the key ways a borrower can maintain the lender’s trust is to submit all required reporting by the deadline. Occasionally there may be extenuating circumstances which could prevent your business from reporting on time. In such situations, it’s imperative that your business request an extension from the lender well in advance of the deadline. Additionally, the borrower should be open, honest, and proactive in their communications with the lender. Lenders don’t like to be surprised when they receive financial statements. Therefore, borrowers should contact their lender early and often to keep them aware of what is going on with the business.
- Focus on simplicity: Another way for your business to keep its lender happy is to make their job as easy as possible when it comes to analyzing the story told by your financial statements. For example, you should consider explaining any significant events that could impact earnings, working capital, or any other key amounts/ratios in which the lender takes interest. You may also want to consider addressing any large losses, large bad debt amounts, or tax planning transactions, such as estate freezes. By including a description of the event and its impact on the financial statements, the lender can easily determine if/how to adjust their analysis (e.g., by backing out the impact).
Certain reporting frameworks, such as ASPE, don’t allow or provide for certain disclosures in a business’ financial statements. Another possibility is that there may be multiple users of those financial statements and disclosure of certain information may not be appropriate for all parties. Separate reporting (such as an executive summary or trends analysis with footnotes) can help tell the right story.
Overall, when a business’ relationship with its lender is strained or deteriorates, the lender is often forced to reconsider the risk rating assigned to the business, which generally leads to a significantly increased cost of capital. Alternatively, if a concerted effort is made to maintain a trusted relationship, the lender is often willing to go the extra mile when times get tough. Lenders should be regarded not only as providers of capital, but also as valuable sources of support, expertise, and guidance for your business.
If you need help obtaining a loan or refinancing, a strategic advisor can help ensure your business is well-positioned. With a deep understanding of what banks and lenders are looking for, we can support you throughout the process so you can feel prepared and confident to achieve your goals.
Visit our Helping businesses gain financial clarity and confidence hub for more insights.
