Consumer and mortgage loans are secured by collateral that is clear and marketable. Security for commercial lending, on the other hand, can be murky-meaning credit unions must be able to glean information from alternate sources.
Linda Keith, who offers how-to workshops on this subject to banks and CUs, told attendees at the California Credit Union League's recent Big Valley Educational Conference here tax returns can be mined for the needed answers.
The biggest drawback of this method, however, is a delay in information. Lenders currently are looking at returns from the 2002 tax year.
"Many credit union lenders are not comfortable moving into commercial lending," said Keith. "You want to get from tax return income to current inflow. When we get a checking account statement from our financial institution, we know it is not up to date, but we know how to reconcile unpaid checks and service charges. The same thing can be done with tax returns."
Lenders examining tax returns must add excluded or new income, deduct non-cash or non-recurring income, and subtract new expenditures and non-cash deductions, she said. For example, some items might not have been tax deductible, but result in significant cash flow-perhaps thousands or tens of thousands of dollars.
"Sometimes a commercial loan may be secured by a personal residence, or a personal guarantee from the owner of the company. However, the lender must make sure the owner is not so strapped he or she can't leave enough in the business to pay off the loan."
There are several "red flags" that may appear in business tax forms that CUs must be aware of, Keith said. Examples include significant drops in discretionary costs, equipment lists that don't make sense, taxes that do not seem sufficient and family businesses that are not paying all family members.
If equipment lists contain unusual items, it can be a clue that something significant about the business is changing, she explained. "Perhaps the focus is going in a different direction, or the owner is gearing down for retirement."
As for insufficient tax payments, Keith quipped: "If a credit union and the IRS are in line to get paid, guess who gets paid!"
Family businesses can be misleading. Lenders must ask who is earning wages. If teenagers are working in a store for free, when they go off to college, the business may have to hire someone to take their place.
Another potential red flag is lawsuits. Keith said if a business is involved in a lawsuit, it is not necessarily bad, but the CU must know the cost to defend. "If the business loses, what is the potential outcome? Will it lose money, or could it be something more serious such as the rights to its best product?"
The most important element, Keith said, is for credit unions to have written guidelines on commercial lending. Especially important are a list of the documentation needed and a standard worksheet.
"Make sure the worksheets are flexible," she advised. "Don't use the same worksheet as in a mortgage loan. Commercial lending worksheets have more items and require more work compared to consumer lending. And make sure people have adequate training so they have the ability to take tax returns and, with confidence, determine if the individual or business qualify for a loan."