How Big Banks Evaluate a Company Before Funding Their Plans?
When a business is looking to secure funding for expansion, new projects, or operations, big banks play a pivotal role in providing the financial resources needed. However, securing a loan or credit from a large financial institution isn’t as simple as filling out an application and waiting for approval. Big banks have a meticulous evaluation process that assesses the overall financial health and risk factors of a company before deciding whether to extend funding.
In this blog post, we’ll dive into the key factors that big banks consider when evaluating a company’s eligibility for funding. Understanding this process can help you better prepare for the loan application process and improve your chances of approval.
1. Financial Statements and Cash Flow
One of the first things banks look at when evaluating a company for funding is its financial statements. This includes:
- Income Statement (Profit and Loss Statement): This document outlines the company’s revenues, expenses, and profit or loss over a specific period of time. Banks want to ensure the business is generating sufficient revenue to meet its obligations, including paying back any loan.
- Balance Sheet:This provides an overview of the company’s assets, liabilities, and equity. Banks use this information to assess the company’s financial health and determine if it has enough assets to cover its liabilities if needed.
- Cash Flow Statement:This document tracks the flow of cash in and out of the business, highlighting how the company manages its liquidity. Cash flow is crucial because it shows whether a company has enough cash to handle day-to-day operations, service debt, and make loan repayments.
Banks are particularly concerned with consistent positive cash flow, which signals that the business can repay the loan without straining its operations.
Why It Matters:
Both business credit and personal credit are important when evaluating a company's loan application.
- Business Credit: Banks look at the company’s business credit score (e.g., Dun & Bradstreet's Paydex Score or Experian’s Intelliscore). A strong business credit score demonstrates that the company has a history of paying bills on time and managing its financial obligations responsibly.
- Personal Credit: For small businesses or startups, big banks may also consider the personal credit score of the company’s owners or executives. This is especially important for companies that have a short or limited business history, as it offers insight into the owners’ ability to manage finances.
Banks typically prefer businesses with strong credit histories, as it minimizes the risk associated with lending. If a business or its owners have a history of missed payments, defaults, or bankruptcies, the bank may view them as a higher risk.
Why It Matters:
A high business credit score (typically above 80 on the Paydex Score scale) and a solid personal credit score (700 or above) indicate to banks that the company has a track record of meeting financial obligations. A poor credit score can be a major red flag and may result in the bank either denying the loan or offering less favorable terms.
3. Business Plan and Use of Funds
A clear, well-structured business plan is crucial in any funding application process. Big banks want to understand how the company plans to use the loan, whether for growth, expansion, operations, or new projects.
The business plan should include:
- Purpose of the Loan: Clearly outline how the funds will be used and how they will help the business grow or improve its operations. Whether it’s for purchasing equipment, hiring new employees, or launching a new product, the bank wants to see that the loan will generate a return on investment.
- Revenue Projections: Banks want to see realistic financial forecasts for the business. This includes projected revenue, expenses, and profits over the next few years. A solid business plan should back up these projections with credible data, market research, and industry trends.
- Risk Management: Big banks are risk-averse, so they want to know how the company plans to mitigate potential risks, such as economic downturns, supply chain disruptions, or changing customer demand.
Why It Matters:
A well-prepared business plan shows the bank that the company is serious, strategic, and capable of executing its vision. If a business can clearly demonstrate how the loan will be used to generate growth or streamline operations, it increases the likelihood of approval.
4. Collateral
For larger loans, especially those that are unsecured or involve significant risk, big banks will often require collateral as a guarantee for repayment. Collateral can include tangible assets like:
- Real estate
- Equipment
- Inventory
- Accounts receivable
- Vehicles or machinery
In the event that the business defaults on the loan, the bank can seize the collateral to recover the funds. Collateral reduces the bank’s risk and provides a safety net if the business faces financial trouble.
Why It Matters:
Offering collateral can make it easier to secure funding, as it provides the bank with some level of protection. If a business lacks significant assets to back the loan, the bank may be less inclined to approve the funding or may offer less favorable terms.
5. Debt-to-Income (DTI) Ratio and Overall Debt Load
Big banks closely examine a company’s debt-to-income (DTI) ratio to assess its ability to take on additional debt. The DTI ratio compares the company’s existing debt payments to its income, helping banks understand how much of the company’s revenue is already committed to paying down debt.
Banks will typically look for a DTI ratio of 36% or lower, though this may vary depending on the industry and the bank’s lending criteria. If a company’s existing debt load is already high, banks may be hesitant to lend more.
Why It Matters:
Banks want to ensure that the company isn’t over-leveraged and will be able to service the new debt without risking financial instability. A high DTI ratio could indicate that the business is already struggling with its debt obligations, making it a higher-risk borrower.
6. Industry and Market Conditions
The health of the industry in which the business operates can also play a significant role in the bank’s decision. Banks are more likely to approve loans for businesses in industries that are performing well or have strong growth potential. Conversely, businesses in declining or high-risk industries may face greater scrutiny.
Banks will consider:
- Market trends and demand for the company’s products or services.
- Economic factors that could impact the business’s ability to generate revenue.
- Competitive landscape and how the business positions itself within the industry.
7. Management Team and Experience
Finally, the management team plays a crucial role in the decision-making process. Banks want to know that the business is being run by experienced and capable individuals who have the knowledge and skills to lead the company through challenges and opportunities.
Key factors include:
- Leadership experience of the business owners and executives.
- Industry expertiseand track record of success.
- Company structure and the team’s ability to manage operations effectively.
Why It Matters:
Banks are more likely to lend to businesses with strong, experienced management teams that have demonstrated their ability to execute strategies and drive growth. A well-rounded team can inspire confidence in the bank that the business will be well-managed and capable of meeting its financial obligations.
Conclusion
Big banks take a comprehensive approach when evaluating a company’s loan application. From financial statements and credit history to business plans, collateral, and market conditions, banks consider a wide range of factors to assess the risk and viability of lending to a business.
To increase your chances of securing funding, make sure your financials are in order, your business plan is solid, and your company is well-positioned for growth. By understanding how big banks evaluate companies, you can better prepare for the application process and improve your likelihood of success.