Most entrepreneurs and business owners are familiar with the traditional 5 C’s of credit as the gold standard by which creditworthiness is determined. This article will take a closer look at how the commercial banking industry evaluates credit requests from small to medium size businesses in the manufacturing and wholesale distribution sectors in the current business environment, which is punctuated by ever-increasing regulatory scrutiny of the lending process.

Outlined below are the first three of several critical components of a typical bank’s credit approval criteria for business loans. The discussion will be continued in a series of subsequent articles covering additional components of this process.

1. Cash flow in excess of debt payments

This is perhaps the most important element in the credit underwriting process. Consisting primarily of net income (after any distributions of profits) and non-cash expenses, such as depreciation, the cash flow generated on an annual basis should generally exceed expected annual debt payments by a margin of at least 25% in order to impress your lender.

Cash flow is usually viewed as the primary source of loan repayment (collateral would be a secondary source), and if this box is not checked, getting the credit you need will be an uphill battle.

While this is not the only criteria needed to win an approval, the inability to meet this hurdle is the most frequent show-stopper found in declined applications. Due to the importance of this category, you will be well served to monitor and protect the integrity of your cash flow at consistent intervals throughout the year (see the next section below for some tips on how to do this).

Also, it is a given that your company’s credit history, or timeliness of payments for existing or past credit relationships impacts heavily on the approval decision as well.

2. Positive historical trend of revenue and earnings

This assumes your business has been in operation for at least 3 years, as most commercial banks will not consider loans to start-ups.

The lender will want to see that both revenue and profitability are generally trending in a positive direction. Consistency in year to year results is important to the outcome. While there can be explainable variances to an uptrend, you will need to clearly articulate the causes of any setbacks, and more importantly, the actions you have implemented to correct them.

Is any decline in revenue or net income due to a one-time or extraordinary event, or has something changed structurally in your industry or company? If the latter, you may want to take an in depth look at your strategic plan, closely evaluate the actions of your competitors as well as your own product offerings, and move swiftly to update your marketing plan if needed.

If expense growth at a rate higher than revenue growth has become a drag on earnings, this is often easier to rectify than sluggish sales momentum. However, it should not be left unattended unless connected to an intentional strategy to support anticipated revenue growth in the near future.

Perhaps the best tools for avoiding roller coaster results are (a) a monthly budget, or projection of all sales and expenses prepared in advance for each fiscal year, and (b) a budget variance report, reviewed monthly in order to identify and address any unexpected negative changes before they become big problems.

When you commit to doing this, the cause and effect relationships connected to what’s working and what’s not will be more obvious at a much earlier stage. And you will have taken a giant step down the path of more consistent and significant revenue and profitability. Even if your lender is not impressed, you the shareholder will be.

3. Diversification of revenue

If you have high revenue concentration, give this category your immediate attention. The definition of what’s high will vary, but certainly if you have a single client who accounts for 40% or more of your revenue, most lenders will consider it a concentration, which will make approval more difficult.

The most compelling criteria here is to ask yourself what the impact on your business would be if you lost 40% or more of your revenue in an instant. The loss of a large client happens more often than you might imagine, and if it does, the prime issue is the survival of your company, not roller coaster earnings. And in many cases, the reason for the loss of the client has nothing to do with poor service, product quality, or price.

You may have been doing business with the client for many years, enjoy a close business and personal relationship, and roll out the red carpet for your very best customer. Despite all of your efforts, sometimes your company is jettisoned because of a change in management at the client’s business, changes in technology, financial hardship or the demise of your client, or any number of possible causes beyond your control.

I have personally witnessed the financial devastation wrought by companies that have been reluctant to diversify their revenue, trusting instead that their best and largest customers would always be there for them. The good news is that you can avoid this fate through recognition of the problem if it exists, proper planning, and by taking corrective action.

All lenders have been stung and have taken losses because of revenue concentrations, and are quite vigilant regarding this issue. More importantly, and closer to home, if you have a single client accounting for even 25% of your revenue, your strategic plan should include revenue diversification as a primary objective. Devise a plan to expand your business to bring in more new clients in order to de-emphasize the dependence on any one customer.

If you own a manufacturing or wholesale distribution company with annual revenues of $5 to $50 million and want to improve your results in any of the areas discussed above, please call 704-575-5809 or email jchristian@trinitas-consulting.com for a free strategy session.

Up Next:

• Industry outlook, product demand
• Balance sheet characteristics
• Liquidity