I’ve thought for a while that an article should be written on how the banks actually assess businesses when applying for overdrafts, mortgages and loans.
Why? As yet, I don’t believe this has been written about properly, and with better information to hand, there is an opportunity for businesses currently struggling to put a plan in place to genuinely get back to the cheapest forms of bank funding available. I’ll show you the exact calculations the banks use to approve or decline, explain the changes from a different perspective, and then demonstrate how you can use this knowledge to put in place a "road map" back to the finance you want, using a simple 2 step process.
Only one Calculation
When we hear applications are a “box-ticking exercise” and a lot of new calculations are used to decline businesses, the reality is there is only one calculation used to decide whether to lend, and it is the same calculation banks have always used; the debt service cover ratio.
The question asked is simply this: If you take out a loan, is your business financially able to pay the monthly repayments? If you can, a bank will lend. If you can’t, they won’t.
Stress Testing, or Rainy Day Testing!
The way the banks do this is by using a method called Stress Testing, or what we might call "Rainy Day" Testing!
The banks want to see that the business can not only afford the monthly repayment, but there is some extra left over, should your business have a dip in income, or a large sudden expense. Essentially: Have you saved for a rainy day?
For example, if you were to lend to a friend, and they are paying you back £20 a month, you would want to know that he was able to pay it back every month. You might also want to know that they had £50 a month coming in spare to do so. That way not only can they pay you back, but they also have leeway should something untoward happen in their finances. The banks operate in much the same way.
Banks stress test by wanting to see that your business has leeway of between 1.5 and 2.5 times the monthly repayment. So if the repayment is £100 per month, they want to see that your business has net profits of between £150 and £250 per month.
Interest Rates: A further consideration
The Banks have one further level on the stress test, and that is they look at the above monthly repayment on a rate 2-3% higher than you are being offered. So if your commercial mortgage will be 3% over base, the monthly repayment they will calculate against will be on approximately 6% over base.
Why is this you ask? Again it is to do with Rainy Day lending, and the ability of the business to continue making monthly repayments should interest rates rise (not an impossible scenario). This is regardless of taking a fixed or variable rate loan, as eventually a fixed rate loan ends.
We are in the unprecedented position of being in a recession, or coming out one depending on what you think, without the benefit of high interest rates coming down. Usually a recession and high interest rates go hand in hand, and the easy way to growth the economy is to cut the base rate, but not this time. With the base rate currently at 0.5%, the UK is unable to do this.
The reality is the Base Rate is likely to go up over the next few years; good for savers, but not homeowners or business. Banks therefore have a responsibility to ensure businesses do not default on loans, mortgages or overdrafts, if and when rates go up. The previous lack of responsibility was why the recession happened in the first place. As a result, the Banks take responsibility and test your business’ ability to pay at the higher rate.
Why this situation is unlikely to change
There are four reasons why I believe the status quo is likely to remain for decades, and why banks will probably not return to lending speculatively as they did pre 2008:
1. Interest Rates will go up, vindicating the stress testing that the banks are doing. Does the country really want to see thousands of businesses in default, again, when rates go up and they cannot afford the monthly repayments? I doubt it!
2. Globalisation has led to a new constant; an uncertain marketplace, which greatly increases lending risk. Whereas in the past bank managers could speculate on a business by increasing overdrafts temporarily, they could do so safe in the knowledge that the local marketplace was predictable. Large global corporates and cheaper foreign labour have greatly increased the risk of doing this, and consequently this strategy is virtually null and void.
3. Banks have no interest whatsoever in defaulting on businesses. It is a time consuming and costly exercise legally, and in the case of repossessing property after defaulted mortgages, the banks are sat on that much stock already, they don’t want to sit on anymore. Why? In a downmarket, or an uncertain one, land and property in a repossessed state does not sell for Open Market Value, but for as little as 30% of that number. If a bank lends at 70% Loan to Value, repossesses and sells at auction for 50%, the bank has lost 20%. They are very retiscent to speculate like this, since they lend with savers money. It is another reason why lending is much more cautious, and will probably continue to be so.
4. We cannot have it both ways. This is really important. The banks are chastised for recklessly lending, but then business owners get annoyed when they cannot access speculative, cheap forms of funding. It was this very form of lending that got us into the trouble we have seen in the first place.
So if the banks won’t lend to us speculatively anymore, we need to find another plan.
The 2 Step Approach to Funding Today
It is possible to get back to bank funding, but it requires a two step process to get there. The cheaper the funding you want, the less risky your business must be. Therefore, if your business is not qualifying for bank funding, your business needs to become a safer bet, and get into a better financial state.
There are various forms of interim funding available which are designed to grow your turnover and profit levels. Whilst the rates are more expensive, these types of funding are usually short-term. Certain types of funding have the ability to grow your business at a quicker rate that would otherwise normally be the case. Once your turnover and profits are up, returning to the bank for much cheaper levels of funding is a very distinct possibility.
Various types of funding exist, depending on your sector and business model. It is about using interim funding in a smart way; if money makes money, then you can put in place a road map to getting back to the banks and their much cheaper forms of long-term finance.
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About Chris Davidson
Chris Davidson is Managing Director of Discover & Invest Ltd.
He believes passionately in providing businesses with market-leading financial insights that have a positive impact on the bottom line. As a result, Chris helps get the best rates and terms available at any one time.