A lender's primary responsibility is to mitigate credit risk by signing off on loans with the best chance of repayment. But in an age when entrepreneurship drives the economy and a bank's slate of financial services gets more varied by the day, lenders should also have a fiduciary role in advising borrowers.
Suppose a business has no debt, high net margins and assets that can be sold easily in the event liquidity is needed. It considers a fixed asset purchase of $100,000. After that purchase and a loan for $70,000 over five years, the business has a debt service ratio of 20; for every dollar of debt that must be paid, the business generates $20 of cash flow. Assume the business has a good credit history, the fixed asset can be sold easily for the purchase price of $100,000 and there are no other warning signs that might alarm a lender.
Most lenders end up making that loan. But what if we also suppose that the purchase of the asset won't meet the company's target for return on its investment? Should the bank still make the loan?
What obligation does the bank have to the success of the business?
When I started my career at a bank in the '80s, the best commercial lenders had a genuine interest in their clients. They were informal advisers, not just on whether the business could service the debt under consideration but also on whether the loan was to the overall financial benefit of the business.
Lenders need to get back to that broader role of advising clients rather than just serving as gatekeepers of credit.
It is important to be candid to borrowers about the drawback of credit, no matter how creditworthy they may be. Many entrepreneurs possess inherent limitations. Most people who run small to midsize businesses are very good at running their businesses, but they know very little about finance. A seasoned lender is a valuable resource to the person running the business. This is one reason I always recommend to businesspeople that they get both a good banker and a good CPA.
We have to be open to the idea that a loan is not always the solution to a business's problems. There is a prevailing notion, echoed in the highest levels of discussion on the topic, that access to credit and capital is the Holy Grail for business success. Sluggish growth? The business must need access to credit. Can't hire more workers? Outside capital will help.
But I have seen no statistical evidence of this. In fact, I've seen evidence of the exact opposite: credit gets overextended and the results are devastating to all parties, most importantly to the borrowers. I speak from personal experience. As a young entrepreneur years ago, I borrowed too much, rather than trying to find the right model to build the business.
When I work with entrepreneurs, I always tell them to tighten their belts until they have a demonstrable and reliable business model, or I suggest that they gather money from equity investors. Equity comes at a higher cost of capital, but it does not come with the handcuffs of having to be repaid at regular intervals regardless of how the business is doing.
This isn't to say that lenders should be turning down prospective borrowers who are creditworthy. But the lender should at the very least give the businessperson honest feedback on the pros and cons of the investment. With this information, the business can make a more informed decision. Think of this as just another factor in creditworthiness.
With the full knowledge of the consequences, most business owners will make the right decision for their business. You may just find that this approach actually reduces the amount of risk at your financial institution.
Brian Hamilton is chairman and co-founder of the financial analysis software and risk management company Sageworks.