When determining whether or not to make a business loan, lenders turn the bulk of the heavy lifting over to staff credit analysts. Analysts, in turn, screw their hats on tightly, warm up their calculators and retrench into orgiastic numbers overload.
What are the business' existing leverage and liquidity ratios? Inventory, payable and receivable turns? Common-size percentages of cost of goods sold, operating expenses, gross and net profits? What about the ratio of cash flow to monthly payments and short-term debts? How about trend analysis — are the ratios generally improving, holding steady or declining over time?
The math required to properly analyze a prospective business loan is substantial. Since the world turned upside-down 3+ years ago, number-crunching has become even more integral today than ever before, with a renewed emphasis on fundamental analysis. Unfortunately, a large percentage of businesses have seen a substantial decline in their financial statements, particularly with respect to negative impacts upon cash flow, liquidity and leverage. These factors have played into the oft-cited "credit crunch", which although improving, nevertheless remains a headwind the economy faces in its attempt to recover from the devastation wrought by the Great Recession.
Character of the Borrower
The first four words of a promissory note read "I promise to pay". The word promise featured so prominently within the central loan document of every leverage transaction indicates the importance of character within the lending decision. Although the borrower's ability to repay the loan as measured by fundamental credit analysis is critical to the likelihood of full, timely repayment of the obligation, in and of itself it is not enough. Borrowers have failed to perform on loans despite having the ability to do so on paper. Likewise, others have continued to service their obligations even when no calculator on Earth can crunch numbers that indicate how they are able to do so.
Character can be divided into two components: quantifiable and judgmental.
Quantifiable Measurements of Character
The primary third-party quantifiable measurements of character are as follows:
- Credit scores
- Background checks
- Income tax verification
Credit Scores
Everybody outside of the most remote hut-dwellers within the city of Oum Hadjer, Chad (and possibly the state of Mississippi) understands the importance of consumer credit scores. Three credit bureaus (Equifax, Experian and TransUnion) report debt repayment histories and calculate composite credit scores via complex formulas that only the NASA science nerds of Rob Reiner's Apollo 13 are likely to understand. The output is referred to as a FICO score, which stands for "Fair Issac Corporation".
Lenders vary on which reporting service they use and what standards they go by. However, unless something randomly pops up on one bureau and not another, the scores tend to be similar across the board. On balance, lenders require personal scores in the mid-to-upper-600's (or better) in most instances.
For businesses, credit reports showing payment information, open trade account data, tax liens, UCC filings and other pertinent data can also be obtained. Likeliness of default indexes can be calculated.
Background checks
Tax status, address verification, criminal background, even citizenship (or permanent resident alien status) can be verified. How previous checking accounts were handled could also be factored into the equation.
Income Tax Verification
Many lenders incorporate income tax verification into their processes. The borrower signs a 4506-T form, which is then submitted through channels, generating a tax transcript. The tax returns the borrower provides are compared to the tax transcripts to ensure what is given the lender matches what the IRS received.
Judgmental Measurements of Character
Alchemy is defined as "a process by which paradoxical results are achieved or incompatible elements combined with no obvious rational explanation".
The most problematic-yet-potentially-rewarding aspects of character determination is when lenders are willing (and able) to employ judgment with respect to character. This is where community banks shine, as they are generally able to see through the din of surface clutter and short-term issues to determine the true character of the borrower. Factors such as previous history, a close working relationship and other less quantifiable components are considered.
Within the judgmental aspects of determining the borrower's true character, three core fundamentals should be weighed:
- Integrity
- Morals
- Principles
Integrity
Integrity is defined as "adherence to moral and ethical principles; soundness of moral character; honesty". It's not enough to possess it; the small business borrower must go one step further and practice what they preach. This concept is critical in a shrinking, recessionary world where asset values are diminishing faster than the associated debt used to acquire them. Credit scores may or may not fully reflect this trait, as the individual may have little debt (and thus, a de minimis credit report) or may have had one-time medical problems or a divorce which skews the results.
Morals
Morals are defined as "of, pertaining to, or concerned with the principles or rules of right conduct or the distinction between right and wrong; ethical." Does the borrower's character indicate they will do the "right" thing, regardless of the circumstances? It's a difficult trait to be completely certain about. When times are good, borrowers typically repay their debts without a second thought; during difficult times, moral compromises can separate those of high character from those without it.
Principles
Principles are defined as "a personal or specific basis of conduct or management". This concept involves the rules one chooses to live by, and where the lines are drawn.
The Alchemy of Character Evaluation
The three definitions above dovetail together, but carry their own separate distinctions. Many elements fit within all three definitions, although some are exclusive to just one or two. Regardless, making a value judgment about the borrower in these three areas is just as critical to the evaluation of overall character as is the borrower's FICO score — maybe more so.
No one statistical metric will fully capture the essence of a borrower's character. Individuals with 750 credit scores have refused to pay their debts, whereas some with 550 scores doggedly continue to make their payments. Although the scores correlate with success, they do not guarantee it. The lender's ability to read the tea leaves and ascertain the true character of the borrower is essential toward making the right decision in the lending process. That is, unless they hail from Mississippi.
Sources:
Walter McLaughlin - I am a 47-year old commercial banker living in the Seattle area. I am an avid sports fan, but also greatly enjoy writing satirical, ...
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