Lower Your Borrowing Costs By Improving Your Company’s Risk Profile

By Eugene E. Valdez

Background

As the founder and president of The CEO Teachers my firm performs many business finance services on behalf of CEOs located in the Inland Empire. Our most popular client service can be reduced to three simple bullet items:

• Creation of loan strategies uniquely designed to allow a CEO achieve their sales and profit goals.
• Documentation of these loan strategies in the form of a written business plan.
• Placement of these loan strategies with a  lender that best fits our client’s “risk profile”

Risk Profile refers to a lenders assessment of the financial condition of a business and its owner. There are a myriad of variables that lenders look at including but not limited to : number of years company has been in business, trends  in their  industry,  company’s competitive position in their industry, quality and experience of owner and management team,  sales and profit trends, leverage and liquidity of balance sheet, quality of accounting systems and outside CPA, quality of collateral, concentrations in customer base, owner’s FICO score and personal credit issues and owner’s personal net worth and liquidity. Issues such as business succession plans and the availability of key man life insurance may also be reviewed.

In essence the lender’s risk profile process is designed to answer the question, “What is the risk that we won’t get paid back if we make this business loan? If a lender believes your company has a poor risk profile they will quote you a higher interest rate to compensate them for the risk they are taking. The good news for CEOs is that it is possible to improve your company risk profiles and thus reduce their interest rate costs accordingly.

Listed below are a few types of lenders. These lenders are ranked by their willingness to take on borrowers with poor risk profiles and their interest rates reflect this.

Factoring 

If you have been in business for only a few months or your company is in very poor condition but you have good paying customers, (accounts receivable) a type of financing that might be available to you is factoring.  Factoring is the process of selling your commercial accounts receivable to a financing company at a discount. Instead of waiting 40, 50 or 60 days to receive payment you sell your invoices to the factoring company who then pays you immediately, usually at 80%-85% of the face value of your invoice.  The costs to factor are very high. It is a temporary form of financing that you should endeavor to move out of as quickly as you can.

• Interest Costs Range- 24% to 48% per annum
• Perceived Risk Profile- Poor to very poor

Asset Based Lending- Finance Companies 

Asset Based Lending is a good fit for companies whose risk profile is strong enough to upgrade from a factor but not strong enough yet to qualify for a bank loan and there are good quality accounts receivable.

Offered by commercial finance companies, ABL or “formula” lending is financing based on the monthly levels of a company’s accounts receivable, inventory and the quality of the customers.  Line of credit advances are based on a “formula” of 70%-80% of monthly eligible ARs and 15%-50% of eligible inventory. AB lending differs from factors in that with factoring you sell your invoices while with ABL you retain ownership of your invoices and simply pledge them as part of the collateral pool.

ABL lenders will organize deals where your debt to equity ratio is north of 4.00 to 1.00, which is a leverage factor that most commercial banks will pass on. If you have quality AR’s, ABL lenders will not pass on a deal if you have lost money in one of the last three years while most commercial banks will.

• Interest Costs Range- 8% to 16% per annum
• Perceived Risk Profile- Average

Commercial Bank Loan- With Third Party Credit Enhancements 

If you’ve been in business at least three years, are breaking even or are moderately profitable, have good or little collateral to pledge, have a moderately leveraged balance sheet, have a good personal financial statement and a decent FICO score, you stand a good chance of obtaining a bank loan. Because your risk profile is not quite strong enough the bank will require some type of third party credit enhancement to do the deal.

The most common third party enhancement programs available today are the Federal SBA Guarantee, State of California Guarantee, and State of California Cal Cap programs.

• Interest Costs Range- 5.5%  to  7.00% per annum
• Perceived Risk Profile- Good

Commercial Bank Loan- No Credit Enhancements 

This is the preferred source and type of loans for most CEOs because the interest rates are the lowest but the challenge is that banks are only interested in lending money to companies with the lowest risk profiles possible. Their underwriting criteria are very strict.

As  mentioned  earlier, typical criteria includes three straight years of growing sales and profits, an abundance of quality collateral, (like real estate), great management team, balance sheet with very low leverage (debt to equity no greater than 2.5 to 1), positive industry trends, very good accounting systems and  a high quality outside CPA. Further, CEO must have very good personal credit, strong liquidity and good net worth as a guarantor for the business loan.

• Interest Costs Range- 3%  to  4.5%
• Perceived Risk Profile- Very Good To Excellent

Annual Interest Costs: Assuming $750,000 In Average Annual Borrowings:

• Factors- $270,000                                                       (used   36.00%)
• AB Lenders- $82,500                                                 (used   11.00%)
• Banks w/credit enhancements- $46,875                     (used   6.25%)
• Banks-no credit enhancements-$26,250                     (used   3.50%)

As you can see above, it “pays” to have a strong risk profile. Interest rate savings float 100% to your pre-tax profits.  As was stated earlier, CEOs have the ability to improve their risk profile by the management decisions they make every day relative to all aspects of their entire operation.

If you feel you need assistance in improving your company’s risk profile then seek out your most trusted business advisor, it is well worth the exercise.

Eugene Valdez is a 40-year veteran of business/financial management and owner of The CEO Teachers, a business coaching and consulting firm based in Upland. He can be reached at [email protected].