By Christopher G. Webbe
Senior Consultant, CEIS
Some years ago, I worked in the credit department of a New York bank. Having expressed interest in getting involved in C&I lending, I was given a small business portfolio to manage. One of the borrowers “Jim’s company,” was part of that portfolio. The company designed and distributed teen fashions. He purchased the rights to some cartoon characters and his business consisted of designing clothes around these characters, getting the clothes manufactured in the Far East and having them shipped to his warehouse in the US. He then distributed them through clothing companies with stores in malls catering to teenagers. My bank would open letters of credit on behalf of Jim’s company to finance the imports, and then finance his sales to the stores.
A potential problem of lending to someone like Jim is that you are entirely in his hands. He will do what he thinks is right for his company. In C&I lending, your customer’s risks are your risks, and the extent to which they decide to take risks and the way in which they manage those risks will determine whether or not they service their debt.
Know the small business borrower
The more you know about your borrower, the better the position you are in to determine whether you can rely on them to make sensible decisions. During your due diligence, you will therefore want to take a good look at the borrower’s track record in business and with the bank (for that reason, lenders are usually reluctant to lend to start up operations).
One of the first things you are going to ask for is the borrower’s financial statements. However, with small businesses it may not be so simple. The quality of your analysis is only as good as the financial data on which it relies, and small businesses may not chose to invest in audited or even reviewed financial statements. Rather, when you receive financial statements from a small business, they most likely will be the result of a collaboration between the principal and his accountant. You may well have no cash flow statement, just a profit and loss and a balance sheet, and you will probably have no explanatory notes. That’s what I used to get from Jim, and I could never be sure of whether they were a true reflection of the company’s financial status.
Whatever level of comfort you do obtain with the financial statements presented, you will be well advised to make contact with the customer’s accountant. With a few judicious questions you should be able to determine how good the accountant is and how well he knows his client’s business.
An additional word on financial analysis – the riskier the business, naturally the more comprehensive you will want your analysis to be. Yet on the other hand, with the size of loan we are talking about, the profitability of individual relationships is going to be limited, so overheads need to be kept within bounds. Credit analysis is useful but in small business lending, my initial focus will still be on the competence of management.