This is the 4th post in a series about bank financing. In Parts I-III, we probed issues such as profitability, cash flow, industry outlook, and balance sheet impact. In this article, we consider the vital roles played by collateral and personal guaranties in the evaluation of credit requests from manufacturing and wholesale distribution companies.
Past and upcoming chapters:
- Cash flow, historical revenue and earnings trends, diversification of revenue
- Industry outlook, product demand
- Balance sheet and liquidity
- Collateral and personal guaranties (you are reading this now)
- Management experience, strategic planning
Two of the most common questions I have heard from borrowers are:
- Why won’t the bank approve my company’s loan request? I’ve got more than enough collateral to cover it; and besides, I’m good for it personally
- My company is very profitable and can stand on its own. Why does the bank need collateral or my personal guaranty?
The answer to both questions can be found in a concept we alluded to briefly in Part I of this series: primary and secondary sources of repayment.
To understand the necessity for collateral and personal guaranties in commercial loan underwriting and approval, consider for a moment your interests as a deposit holder in a bank, as well as a bank’s interests as a for-profit organization in a highly regulated industry. In many ways, these two interests essentially merge for purposes of answering our questions above.
The regulatory environment (as well as market forces) places limitations on how much credit risk the bank will be able to bear. The regulatory aspect is meant to ensure that the bank makes only low risk loans so that depositors will enjoy ample safety and security in connection with their deposits. Additionally, low risk loans should correspond to lower loan interest rates, and in fact, most bank loans are made at prices substantially lower than can be found from other types of lenders.
It goes without saying that a thinly priced loan portfolio cannot withstand many losses before both the bank and its depositors begin to feel the heat. But even the most diligent and conservative underwriting processes cannot prevent loan defaults. As such, both stakeholder groups are highly motivated to mitigate losses when defaults occur. As mentioned earlier, this mitigation comes in the form of multiple sources of repayment.
Typically, the primary source of repayment is the company’s profitability, or depending on the loan type, conversion of trading assets. If the primary source fails to keep the loan from default, the secondary source, collateral, provides the next buffer of protection from loss. The personal guaranty can be either a secondary or tertiary source of repayment, depending on the nature of the loan agreement.
Many borrowers contend that the combination of consistent profitability and good collateral coverage should be sufficient for loan approval without a personal guaranty. However, for closely held companies, most banks won’t even consider lending to a company if its majority shareholders show any reluctance to guaranty the debt. Since debt always enjoys senior rights in relation to equity in the capital structure, the requirement of shareholder guaranties is essentially a litmus test. If equity holders are unwilling to accept the risk of repayment personally, the lender will view this as a lack of confidence in the enterprise on the part of the ownership, and certainly will not take on a risk that is too great for the shareholders.
In summary, neither the bank nor its borrowers can predict which loans will succumb to default, but it is a certainty that loan defaults will occur. When they do, the existence of collateral and personal guaranties substantially reduces, and in some cases eliminates credit losses suffered by the bank. This allows the bank to maintain its loan portfolio with a much lower risk profile, affording greater protection to deposit holders, and to retain the financial strength supportive of the modest loan interest rates associated with lower risk lending.
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 in this series of articles, please call 704-575-5809 or email jchristian@trinitas-consulting.com for a complimentary Profitability Optimization Session.