Our last few episodes have been focused on about cash flow and a big part of that discussion has been ensuring that your business has a back up plan toprepare for any times of cash flow crunch. In developing that back up plan, you will likely need to work with a bank. That’s why we thought it would be advantageous to invite one of our good friends, Jeffrey Boundy from Cornerstone National Bank & Trust Company, on the podcast to talk about options available and how to make your business more bankable.
What we cover in this episode:
- 01:58 – Introduction to Jeffrey Boundy
- 12:55 – Leverage your professional network
- 15:44 – 7 factors that can make your business more bankable
- 22:53 – When is a loan better to use than a line of credit?
- 24:39 – Why it’s important to avoid concentrations
- 25:56 – How can you make your business more bankable?
- 39:45 – Current trends and interest rates
- 42:59 – Things to avoid and banking best practices
Introduction to Jeffrey Boundy
Jeffrey T. Boundy, president and CEO of Cornerstone National Bank & Trust Company, has been in the commercial banking industry for over 30 years and Jami Johnson actually used to work with him at Cornerstone. He founded the company in 2000 so they could focus on companies that were privately held rather than publicly traded companies. His view on banking is that first and foremost, a business bank should be a consulting firm and the banking services become a coincidental product.
7 factors that can make your business more bankable
The old cliche that banks want to give you money when you don’t need it is very true and is why we recommend you set up a line of credit before you need to use one. If you are currently in a high-growth phase, and haven’t set up a line of credit with a bank, now is the time to do it. From a timing standpoint, depending on the bank, your outside time is probably 30 days, but the bank should be able to do it within about two weeks.
The bank will look at some simple factors, including:
- Overall leverage – This is found in your balance sheet. Banks want to see tangible equity in the company. One ratio Jeff pointed out that traditional commercial banks will take a look at is tangible equity. Banks will look to ensure that the company has less than three to one leverage, meaning less than $3 debt to every $1 of equity.
- EBITDA – This is earnings before interest, taxes, depreciation and amortization. The easiest way for you to look at it is to start with your net profit. If your company is paying taxes at the company level, not personally, add back your taxes, add back the interest you pay to any creditor, and add back your depreciation and amortization. This is the calculation that banks are going to look at. For more on EBITDA, this article by The Balance gives more detail. EBITDA is a method used to measure cash flow and takes interest and taxes out of the equation, whereas cash flow is a bit different, explained next.
- Cash flow – There are cash flow statements the bank will look at as well. If you’d like to learn more about the two cash flow statements (direct vs indirect), we discuss this in depth in episode #22: How to Take Control of Your Current Cash Flow Situation.
- Required leverage payments – Required leverage payments focus on balance sheet driven leverage. This could include a capital lease, or more traditionally, your principal and interest (P&I) loans that could be there for a piece of equipment or a building. Alternatively, it could be the interest you have on your line of credit. A bank is only looking at the required payment of what the interest is, not $1 of principal. If you listen to episode #22: How to Take Control of Your Current Cash Flow Situation, another term for required leverage payments is principal payments on debt.
- Explain how discretionary your compensation is – Jeff gives us an example to highlight the importance of this component in lending. “We’ve got a client that was making $2 million a year in profit, and they were pulling $2 million a year out of the company, because their company was pretty healthy. Their company then had some challenges, and the revenue dropped back. Well, the owner still wanted to take $2 million. Banks would normally look at that as negative, but then we want to understand that owner’s ability to reinvest it if they need to, and then did the owner need the money? In this case, the owner didn’t need the money, so the bank still looks at it as favorable.” When you educate the bank on what’s really necessary when it comes to compensation, the bank can understand their investing decision and their personal investment profile.
- Collateral – Banks love collateral but never want to collect it. If you look at banks, the most money they spend is in trying to perfect and monitor collateral that they never want to get. So from a collateral standpoint in a traditional business, advanced rates against inventory, most banks will advance 50 cents on the dollar per inventory unless it’s perishable, or unless it’s specialty.
- Receivables – Banks will lend on the completed receivable. They will lend 80 cents on the dollar. Sometimes you’ll see banks get a little more aggressive or a little less aggressive, but that’s probably the 90% rule is 80 cents on the dollar, so 80%. While the business owner’s waiting to collect, they still have to pay for their product, their inventory. They also have to pay for all of their staff. That’s where that line of credit is so important.
When is a loan better to use than your line of credit?
A loan would be used for any type of permanent investment. It could be leasehold improvements into the property into the physical plant space of the company. It certainly could be for a building, and it could be for equipment.
The line of credit really should be focused on that working capital component that is mainly supporting either inventory or receivables. One thing you should be looking at is payables. Many clients think having payables aren’t associated with additional costs. For example, if you get terms through a vendor, you may assume that doesn’t have a cost, whereas a line of credit has interest. But Jeff points out, “We tell them right away, ‘Did you ask the vendor if they’ll give you a discount?’ If the vendor will give them a 2% discount for payment within 10 days, or they pay the full balance within 30 or 45 days, that’s way more of a positive impact for the client to use the line of credit versus not taking advantage of the discount. So we show them the math of that, and again, that’s that relationship of getting to know the bank.”
Why it’s important to avoid concentrations
Banks don’t like high concentrations. If you have a major manufacturer where a large portion of your product comes from, or a customer who provides a large percentage of your revenue, banks don’t like that. Jeff has seen this in the past. In this instance, the customer that was providing the majority of their client’s revenue had some financial hardship. In this case, Jeff’s client had a good margin. They were curious what they should do and how they should drop that client. Jeff was able to introduce them to an outside firm who ensured the receivable. The risk of that client was mitigated. The concentration was still there, but after getting the insurance from that firm, they weren’t as concerned about continuing to do business. In this case, the client had a strong enough margin. They didn’t know that answer was out there but Jeff was happy to step in with a solution that allowed them to continue doing business.
How can you make your business more bankable?
Prepare your financial statements. Start by asking your banker for a list of what is needed. Typically, banks will ask for a current year-to-date statement, your accounts receivable and accounts payable aging reports. They’ll also usually send a blank personal financial statement. Personal Financial statements can usually be completed within about 10 minutes. You’ll want to gather these statements for the least three years.
Those financials are very important, because the bank will want to understand what is owed to you, who it’s owed from, what’s the turnaround time, how much is that converting to cash, etc. They don’t like to see receivables that are greater than 90 days past due. After analyzing the receivables, they will turn to payables. Banks would prefer to see their clients are owed money much longer terms than they pay money. If it’s the other way around where they’re collecting in 30 and paying in 45, well, then there should be pretty heavy cash balances they’re sitting on for a lot of money tied up in inventory. Those are things that banks are going to look for, but I think that they could do to benefit themselves, set up a meeting, and come in prepared.
Prepare for an appointment with your banker. Ask to make an appointment with somebody in the commercial banking area. You’ll want to know the answers to the following questions:
- Where are you trying to head in your company?
- Where do you think revenues are going?
- What are your plans for those funds? Are you planning to invest in staff?
You may even be able to send your financial statements to your banker before your in-person meeting. That allows the banker to make more informed decisions during the meeting. Jeff pointed out, “If I have somebody that already looks very strong when they walk into the meeting, well, we’re going to be a lot more aggressive. It’s a very real conversation, because it’s not like I just want to extend a bunch of credit to you that you don’t need. It’s going to be a much more tangible conversation to what type of pricing we could give them.”
Proactive communication. If you have an established relationship with the bank, proactive communication is essential. The mistake that business owners make when times are bad is they assume they shouldn’t communicate to the bank because it’s going to just be a negative discussion. If the bank at all feels like it’s a client that can surprise them with bad news, the banks will get much more costly. Banks will get much more conservative, and they will not be as friendly to help because they feel that that trust factor is a major concern. The clients Jeff has seen with the most success will give them a heads up that, “I’m concerned this is where this is heading.” Then when something does happen, there’s not an alarm that goes off. So banks don’t increase interest rates, freeze lines of credit, and will keep working capital open to them. Bankers have the knowledge to help their clients brainstorm ways to either adjust through a cycle, reduce cost and protect themselves.
Be open to other solutions you may not have considered. Banks can help in quite a few ways that you may not be aware of. Jeff says “We can help them with creditors. We can help them negotiate deals that would protect them. So our goal at the end of the day is to help the owner of the business, help their staff and their team be safe and succeed at what they were trying to do, and how do you get from point A to point B.” Sometimes your banker can come in with a solution, like we addressed in the concentrations section that can save your business!
Leverage your professional network. When you can work with your banker in a more collaborative way, it makes banking much more interesting. By communicating with your attorneys, CPAs and your bankers and allowing a team approach, your rewards will be much larger. It is impossible to be an expert in everything and no one person should bear the burden. You want to surround yourself with people that help you know what you need to work on. You should be meeting with your professional network regularly. If you only meet with your banker or CPA once per year, you are not getting the value you should be out of that professional relationship. Many of the “aha” moments come out of regular health checkups that have no task associated with it.
Everybody needs to collaborate. If your team doesn’t talk, you lose. Sometimes, we tend to get tied up in tiny numbers, but we miss the overarching picture and the overarching value that comes from collaboration because that’s where your strategy is found.
Current trends and interest rates
Current trends. We asked Jeff what trends he has been seeing in the banking industry. His response was, “You’re going to see fees continue to be a bigger dialogue, because they’re [banks] going to have to charge for the cost of their services, since they’re not making it up in interest rates.” The bank may call it a loan documentation fee, processing fee, or another name, but he expects clients to see a little more in fees.
So, how can business owners get around that? Jeff suggests having a dialogue to avoid surprises. He recommends asking the following questions:
- What is the total cost picture going to be?
- May I please have a term sheet on your rate structure as well as your cost structure estimated for me?
Interest rates. Interest rates are based off of the prime index, which is 4.75 at the time of this recording, or they’re based off of a LIBOR index. Usually, the LIBOR index is a 30-day LIBOR. All in all, the end rate to the client traditionally right now for working capital financing is in the upper fours. That’s where the most of them. If you get a very strong client, you can get into the upper threes, but that gives you a range from a pricing standpoint of what customers can expect.
Jeff again stressed the importance of building a relationship with your banker. They can help you discuss cash flow, how to best utilize any extra cash and help you with a short-term or long-term strategy. Your banker can help you invest in yourself and your staff and analyze how to achieve your growth goals.
Things to avoid and banking best practices
Inform yourself about swaps. Be careful with swaps. Swaps seem like a great idea, but they can be dangerous. A swap gives the borrower the ability to borrow from a bank at a low, fixed rate. The bank is going to receive a floating rate. They will take that instrument and hedge it in the marketplace for a fixed rate to the client. An example would be a client could get a swap for five years at say 3.5% percent. This sounds incredible. So they go and lock in a rate. There’s not a prepayment penalty, but a swap has what’s called a yield maintenance. So if they chose to pay that loan either in advance or paid off early, the risks they run from market rates to continue to decline is enormous. In round numbers, if somebody was doing a seven-figure loan, a lot of times people would say, “If I pay it off early, I could have a 1% prepayment penalty.” Well in a swap, that percentage could work out to be 10%. So they have to be careful, because if we see continued drops in interest rates, swaps can be very dangerous for people.
Understand your terms. Understanding your terms on any type of lending you receive is crucial. 10 years ago, there were not as many prepayment penalties and now they’re very common. Gain a true understanding of what your terms, interest, penalties, etc. look like for any lending before you agree.
Get to know your bank. This is one of the best ways to safeguard your business. By developing a working relationship with your banker, you can talk about how you can protect yourself from risk with concentrations, opportunities to ensure receivables, liquidity, etc.
More about Cornerstone National Bank & Trust
If you’d like to reach out for more information, please visit their website.
Cornerstone National Bank & Trust Company was founded in Palatine, IL, in October 2000, on the principle of developing long-term relationships with individuals, families and small to medium-sized businesses by providing a full array of the highest quality financial products and services. For businesses, we offer commercial lending services including equipment, real estate and construction loans and operating lines of credit as well as business checking accounts. We also offer association loans for condominium and townhome associations.
We invited president and CEO of Cornerstone National Bank & Trust onto the show today to discuss the factors that affect lending decisions, how to make your business more bankable and current trends in the industry.
Jeff runs through 7 factors that can make your business more bankable. These include overall leverage, EBITDA, required leverage payments, cash flow, explaining discretionary compensation, collateral and receivables.
We then asked Jeff when it’s better to use a loan over a line of credit. He explained that a loan would be best used for permanent improvements like building improvements or equipment. A line of credit would be used for working capital to support receivables or inventory.
We then touched on the importance of avoiding concentrations. This is a heavy reliance on one manufacturer or receiving the majority of revenue from one client. There are options that your banker could be aware of that can help you in this instance though, which takes us into our next point. How can you make your business more bankable? The first way is to prepare by gathering your financial statements. You may ask your banker for a list of what is required. Next, you’ll want to set up a meeting with your banker and prepare your answers to commonly asked questions. Next, proactive communication is essential to success with your bank. In communicating openly, there may be solutions that your banker could present that you may not have considered. And lastly, leveraging your professional network is so key to taking the most value away from these relationships.
We asked Jeff about current trends and interest rates he is seeing in the banking industry right now. He notes an increase in fees due to the falling interest rates and recommends some questions for business owners to avoid any surprises in this area.
He also gives some things to avoid and best practices, like being aware of swaps as well as fully understanding the terms of any lending and building a relationship with your bank and banker.