One reason the US government is anxious to bail out banks is because banks drive a lot of the growth in our economy by loaning money to businesses. To help you understand how banks work let’s start with a couple of basic requirements all banks have to meet.
Reserve Ratio: Banks take in deposits, but then they turn around and loan those deposits back out to businesses large and small. Federal law requires typical banks to keep 10% of their deposits in either cash or a reserve account at the US Federal Reserve. That means a bank can loan 90% of deposits to customers.
Capital Adequacy Banks must also calculate their capital adequacy ratio which is their total capital divided by a weighted formula of outstanding loans. Asset backed or collateralized loans (loans secured by real estate, investments or other assets) count ½ of their value. Working capital loans (loans based on the creditworthiness and expected earning ability of the business) count for their full value. So asset backed loans don’t count as much of a negative in the formula as working capital loans. Usually the required ratio of capital to loans is 8%.
Knowing that a bank has to meet a reserve ratio, you can understand why they want you to maintain all of your bank accounts at their bank. Your account deposits help the bank meet their reserve ratio requirement. Understanding capital adequacy will help you decide the type of loan you want to seek. Obviously if you have some assets to put up as collateral, it will be easier to obtain the loan and you will likely receive better interest and repayment terms.
The bank will also want additional information from you, regardless of the type of loan. A basic P&L (profit & loss) statement is almost essential. The bank may ask for a P&L statement monthly, quarterly or annually. If you use Outright.com, you can create a profit and loss statement directly off the site. Click on the reports tab and a monthly P&L statement will be the default. You can use the drop down where it says “view by:” to select monthly, quarterly or annual time periods.
Any of the reports can be exported to Excel by selecting the link “Export Report” at the bottom of each period’s column. In Excel, you can format the report and print or email the P&L to your banker.
There are specific business ratios the bank will calculate from your financial statements. While there is no one right answer for every bank and every loan, it will help to know if your ratios are comparable to usual guidelines.
Debt to Equity Total Liabilities / Total Equity
$133,000/233,000 = .57 Banks typically like to see a ration of 2.0 or less. This tells the bank how much equity you have in the business vs. how much is based on credit.
Current Ratio Current Assets / Current Liabilities
$11,000/35,000 = .31 Banks like to see a current ratio of 1.5 or greater, although current ratio can vary from industry to industry and you can often make a case to the bank if your current ratio is comparable to other businesses in your industry. This tells the bank your ability to meet your current obligations.
Coverage Ratio Operating Income / Debt Service Payments
$174,500/64,500 = 2.71 Banks usually want a debt service ratio above 1.15. This indicates your ability to meet your debit and lease obligations from the cash flow generated by the business.
Times Interest Earned (Profit before Interest and Taxes) / Interest Expense
$183,500/10,500 = 17.5 A bank will want a ratio of 2 or higher showing that your business is capable of servicing the interest expense.
Quick Ratio (Current assets – Inventory) / Current Liabilities
$11,000/35,000 = .31 Generally a bank is looking for a ratio of 1.1 or greater. Obviously, this ratio only applies if your business has inventory.
Most banks will also want a balance sheet at least annually. Typically, you will create a balance sheet for you and your business combined, as most banks expect an entrepreneur or small business owner to personally guarantee any business loans. Here is a standard format of a balance sheet created in Excel.
When properly managed, debt can provide resources to grow your business. It can also be a disaster if it hides bigger problems in your business. I hope understanding the basic financial information a bank will be looking for, can make it easier if you do need to obtain a loan.
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