What Lenders are Looking for in a Soft Economy

As business activities slow down, lenders shift their focus toward specific aspects when evaluating financing requests. In such times, lenders scrutinize certain items more closely to assess the viability of providing funds. Let's discuss four key factors that business lenders prioritize during the review process. By examining these essential business criteria, lenders aim to make informed decisions that align with the financial stability and growth potential of the businesses they support.

While this discussion focuses on business acquisition financing, these same principles apply to most businesses. Macroeconomic conditions, interest rates, and rising input costs are all affecting the bottom line for many businesses. This brief discussion is not inclusive of all the credit factors reviewed in making a credit decision by a lender, but more emphasis may be placed on these criteria.

Post-Closing Liquidity

The post-closing liquidity of a borrower or guarantor, following the equity injection (down payment) and loan closing, plays a significant role in evaluating the risk associated with a loan. While there isn't a definitive guideline, a higher level of liquidity is generally favorable. Liquidity encompasses various assets, including bank accounts, marketable stocks and bonds, retirement accounts like 401K and IRA, and of course, cash. Additionally, a line of credit with an available balance can provide supplementary liquidity for the business after the loan closing. Many lenders offer a revolving line of credit to ensure a readily accessible source of funds for operational expenses and input costs such as materials. Depending on the specific purpose of the funds, the loan closing may also consider permanent working capital. The saying "cash is king" holds true, emphasizing the importance of maximizing liquidity. Therefore, it is advantageous to have a higher level of liquidity in any scenario.

Experience

Lenders now place heightened scrutiny on the expertise and background of the buyer/borrower. While possessing direct experience in a particular industry or business type is optimal, it is often not a strict requirement. In the absence of direct experience, relevant experience can serve as a favorable substitute. Such relatable experience provides a strong foundation for effectively operating and managing the proposed business. For instance, consider the scenario of purchasing an HVAC business. Although the buyer may not have previously owned or managed an HVAC company, someone with managerial experience in the industry or a similar construction-related business would be a promising candidate.

In cases where the primary buyer lacks any relatable experience, lenders often find reassurance in the retention of a key individual currently employed by the company, particularly when the buyer has yet to obtain the necessary licensure. An example could be retaining a general manager or operations manager who is already associated with the business. Although this individual may or may not possess company stock after the closing, they would typically be retained under an employment agreement. Lenders with flexibility will consider any sound arrangement that aligns with the circumstances at hand.

Existing Pipeline

The assessment of an existing pipeline of business or work in progress holds significant importance for lenders. It provides valuable insights into the current state of the business and the number of ongoing projects. Comparing the current pipeline to the same period in the prior year offers a valuable gauge of whether the business is experiencing growth, decline, or maintaining stability. A critical aspect to consider while reviewing the work-in-progress is the pricing of the projects. Specifically, it is crucial to determine whether the current projects are yielding profitability or if escalating input costs have narrowed the margin to a break-even point or even a loss. This is an important discussion to have with the seller of the business, as it serves as a key focal point of discussion with the lender. Businesses that demonstrate the ability to adjust their pricing to offset increases in input costs are more likely to navigate a slow economy with greater resilience.

Income and Revenue Trends

Lenders typically request year-to-date financial statements and often require a comparison with the corresponding period of the prior year. For instance, they may seek a 5/31/23 statement alongside a 5/31/22 financial statement. Conducting this comparative analysis of revenue and income trends allows for a comprehensive understanding of how the business is influenced by the economy and other factors. Examining fluctuations in revenue and income during similar periods provides valuable insights. Is there an upward or downward trajectory in revenues? If so, to what extent? Furthermore, it is essential to evaluate the impact of rising input costs on the bottom-line income. Understanding the dynamics of the business's financials, including changes in revenue and expenses, becomes paramount, particularly in an economic environment experiencing a softening trend. Acquiring timely and accurate information plays a pivotal role in making sound decisions, especially when contemplating substantial investments such as acquiring a million-dollar company. It's crucial to recognize that the focus of evaluation should be tightly centered on cash flow, as assets without income-generating potential hold limited value. Ultimately, the assessment should revolve around the stream of cash flow generated by the business, with the assets serving as mere means to achieve that objective.

From assessing post-closing liquidity and the borrower's experience to analyzing the existing pipeline of business and scrutinizing revenue and income trends, lenders strive to make informed decisions that align with the financial stability and growth potential of the businesses they support. By delving into these essential aspects, lenders can better gauge loan risk, ensure the viability of the business, and navigate the challenges presented by a softening economy. In this dynamic environment, staying informed and adaptable becomes paramount, enabling lenders and borrowers alike to make prudent decisions and foster sustainable business growth.