When The Bank Says No

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For this report, INC. surveyed 150 of the largest banks in the county (see table on page 50). Among the questions we asked were: What are the major problems in dealing with small businesses? What were the major reasons for rejecting small business loan applications over the past year? And, what are the characteristics of the ideal small business borrower? No matter how we posed the question, the bankers' message came through loud and clear: Small business has too much debt!

That may sound odd coming from people falling all over each other to lend you money. But high debt-to-equity ratios signal risk, to which bankers are highly averse. "Understand that banks are not really in the risk-taking business," says George S. Arneson, president of Arneson & Co., a Kansas City, Kans., consulting firm. "They're lending someone else's money, and when you look at what they're paying for their money and their administrative costs, their gross margin after bad debts is not that great."

Last year, the National Federation of Independent Business surveyed several thousand NFIB members about their banking relationships, and it made the same discovery as INC. Among the 377 who reported recent loan refusals, the most frequent reason given by the bank was insufficient equity or too much debt.

The solution isn't to get more equity. That would be ideal, but most small businesses stay highly leveraged precisely because they can't find equity. Rather, getting around bankers' reluctance to add to your debt involves a combination of less-than-ideal fixes.

Frequently banks send their rejected loan applicants to a commercial finance company. The bank may even own the finance company, making such referrals a lucrative proposition for it. Occasionally finance companies come through with cash when banks won't. But they demand strong, convincing collateral and charge four or five points over prime to boot. These lenders don't judge you by your chances of growing and prospering; they just count up what your assets would be worth on liquidation.

At banks, collateral fills a different role. A loan officer seeks above all a continuing customer; he'll ask for some collateral just in case he's wrong. Frequently, the pledged assets wouldn't recoup a bank's full investment, anyway.

"No bank that I know of would make a loan secured by a basket full of gold bricks if they really thought they would have to sell the bricks," remarks Richard S. Bibler, executive vice-president of First Wisconsin National Bank of Milwaukee. "No matter how much collateral you pile on the loan officer's desk, he's not going to make the loan if he thinks he'll have to liquidate. Banks aren't pawn shops."

Consultant Arneson cautions against pledging all one's assets for a single loan. "Many companies, when they come in to borrow, haven't planned for enough," he says. "They may ask just for the minimum they want, and most likely it isn't adequate to do the job to begin with. If you don't borrow enough the first time, you almost always have trouble getting your next loan, because all your assets are tied up and you haven't anything left to pledge."

For companies with truly insufficient equity to please loan officers, the mission becomes cajoling more use out of the existing capital base. One crucial variable is net working capital (current assets minus current liabilities). That's the amount of equity used to finance day-to-day operations, the rest being tied up in long-term assets such as plant and equipment. Successfully juggling inventory, receivables, cash, and payables can create a sizable chunk of net working capital where little was before. That could warm the heart of a lending officer, who's probably been inculcated with the principle that net working capital should be about equal to current liabilities.

Bernie J. Grablowsky, a professor of finance at Old Dominion University in Norfolk, Va., surveyed Norfolk small businesses with up to $5 million in annual sales and found that they kept an average of $30,000 sitting in the bank all year for each $1 million in sales. If money markets are paying 15%, then that sum could be earning $4,500 a year in interest. Put to work financing current operations -- such as by buying more inventory and paying for additional labor -- it might earn several times that much.

And that was only the money that these business people knew they had. Often entrepreneurs don't really know how much cash they have available. The float on checks sent out and on deposits made leaves a fuzzy area around most business checking account balances.

Perhaps some of these cash balances were fulfilling compensating balance requirements on loans, but probably not many. For example, finance professor Philip L. Cooley of the University of South Carolina, along with Richard J. Pullen of Canada's Confederation College, surveyed 180 companies across the United States who market petroleum products. They found that among those with less than $1 million in assets, only one in five was required to keep compensating balances. For those with over $1 million in assets, the proportion was about one in four. These figures probably resemble those of small companies in other industries.

Another solution to the cash crunch, which many businesses rely on heavily but perhaps don't appreciate enough may be to "borrow" from suppliers.

There are some creative ways to do that. Stephen J. Gurgovits, executive vice-president of the First National Bank of Mercer County in Sharon, Pa., writes letters of credit for some of his customers. That's a contract, used widely in international trade, guaranteeing the suppliers payment in case the buyer of the goods defaults. Gurgovits says that some suppliers offer their customers better terms on advances than the bank could give. "We look at it this way," he explains. "It gets a better deal for your customer, and they pay us a fee for the letter of credit."

A letter of credit costs a fraction of a loan in the same amount because the bank commits none of its funds to the transaction -- assuming, of course, the customer doesn't default. The fee is an insurance premium; the bank acts exclusively as insurer.

There's a good reason why suppliers frequently offer their customers much more generous terms than a banker would. For example, suppose a supplier sells $10,000 worth of goods to a customer monthly on 30-day terms. In a year, he sells $120,000 worth of merchandise to him.If the customer ordinarily pays in 30 days, the supplier regularly keeps $10,000 at risk in outstanding receivables to his buyer. If the supplier makes a 10% before-tax profit on his sales, then he earns $12,000 a year on the continuing $10,000 invested in the receivable.

That's a 120% return on his investment. If a bank, on the other hand, were to lend the customer $10,000 to finance the payables for 30 days over the course of a year, it could earn only, say, 15% to 20%, or $1,500 to $2,000, on the same investment.

This supplier is a good candidate to approach for longer terms. Extending them to 60 days would still earn him 60% of his investment. Why should he cut his return in half? He might be very amenable to giving a good customer some leeway during trying times.

Supplier credit, in fact, is a bigger source of debt capital to small manufacturing firms than bank loans. According to the Federal Trade Commission, small business trade accounts and notes payable added up to 17.2% of their total assets in 1978, while bank loans of all kinds accounted for 16.5%.

By borrowing money when cash could be squeezed out of current operations, a small business pays twice: Once to the banker, and once by losing the opportunity to use idle dollars in the business. Plenty of small business managers recognize that they could manage working capital better; they just don't have the time, they say. The typical financial officer of a small company has his hands full just maintaining the books, placating the creditors at the door, and keeping the company solvent.

But many entrepreneurs need to take time out to brush up their financial knowledge. With plain old cash worth as much as 20% a year, all the old textbook techniques of managing receivables, payables, cash, and inventory are worth two to three times more than just a few years ago. Some who seek money from banks could find it instead in their own backyards. Many have no choice.