Your banker’s perspective on lending

We’ve established in previous columns the incredible return on capital by adding customers, and the fact that appropriate leverage through bank debt can significantly increase your returns.

As we examine the use of leverage and get comfortable with debt as an ally and not the enemy, the question becomes what is the appropriate level of debt for your business?

We went to the experts – the lenders – to gain insight into their perspective on the appropriate levels of debt for a growing company.

We spoke with Joe Dancy of Wachovia Securities, Charlotte, N.C.; Phil Worden of Bank of America, Kansas City, Mo.; and Chris Amburgy of Bank of Oklahoma, Tulsa, Okla. The answers we got reflect how bankers look at a business and the parameters they use to assess the appropriate levels of debt.

Our lenders concur on what I call the fundamentals of lending to small businesses, and they view the loan opportunity in two fundamental ways. One practice values the assets available as pledged collateral against the loan. The other values the stream of cash flow to service the debt and other needs of the operations.

Let’s look at both. We’ll consider the total debt needs of the business, but will ignore the seasonal aspects of the working capital needs.

Asset methodology

In our industry, the primary assets are the tanks in the field, tanks on the lot and rolling stock. Real property, and inventories of propane, appliances and parts can vary greatly among propane retailers and differing lease-or-buy philosophies. Under this asset-based methodology, the lender arrives at a value of those pledged assets that are used as collateral against the amount borrowed.

In theory, the lender will establish the amount of net cash proceeds in the event the business were to be liquidated. Based on the quality and marketability of the assets and the valuation process, the lender will arrive at an acceptable ratio of pledged assets to the borrowing level.

A lender’s primary focus under this approach is the ongoing evaluation of the quality, quantity and value of the assets pledged. A sale of assets by a borrower can trigger a required reduction in the amount borrowed. Likewise, buying new assets – such as tanks – can allow for an increase in the borrowing limit.

An important consideration here is the method that the banker uses to establish values on the assets. Different valuation methods can cause large disparities in lending levels. Often book value understates the true higher market value of some assets. This is generally true of domestic tanks, which are the primary assets in our industry.

Cash flow methodology

As an alternative, many bankers will examine the future earnings of the business to ascertain the borrower’s ability to pay the debt level. Bankers tend to use EBITDA (earnings before interest, taxes, depreciation and amortization) as the primary measurement tool because it provides an unbiased evaluation of the earnings without the impact that various capital structures and depreciation methods have at the net income level.

Generally, a lender will examine the following financial components:

• Level of annual cash flow
• Stability and predictability of the annual cash flow stream
• Debt service of interest and principle payments
• Annual maintenance capital requirements
• Tax obligations

The banker will test the cash flow using several operating assumptions and stress cases to determine the variability of cash flow and the risks involved at various lending levels. In our industry, the general lending ratios range up to two to three times the borrowing limit to annual EBITDA. So, if the business has annual EBITDA of $500,000 the maximum borrowing limit may be between $1 million and $1.5 million.

Note that from a lender’s perspective, the greatest comfort and flexibility of lending covenants is often tied to the predictability and stability of the cash flow. Large fluctuations in the annual cash flow stream without reasonable explanations make lenders uncomfortable and will restrict your borrowing capacity.

Talk with your banker

This brings up several questions to consider as you talk with your banker.

Which methodology does your banker use to analyze your business? If it’s the asset methodology, what is the basis of the valuation they use to lend against? Do they use historical book value of the assets or a more realistic current market value?

If they use the cash flow approach, how do they analyze your cash flow? How often do you discuss the elements of your cash flow with your banker? Do you frequently talk about the details of your financial statements? Do you point out and provide details on the non-recurring vs. recurring items within a reporting period? Does your banker understand historical weather deviations and your product hedging strategies?

If your banker does not use the cash flow approach, why not? Consider this an opportunity to better educate your banker about your industry. Does your banker understand the significant cash flow impact of setting a new tank?

Consider this an opportunity to increase your relationship with your primary source of capital and ultimately improve your borrowing capabilities.