It’s true. Banks and financial institutions definitely speak a different language. Unfortunately, they are not bilingual and they don’t speak yours so it’s very important you learn theirs when you are trying to get financing from them.
It’s also important to understand that banks are heavily regulated and have to answer to those regulators at least once a year with respect to the loans they make (and sometimes about the loans they don’t make). Additionally, banks tend to operate on fairly thin margins with respect to those loans so they want to know all the details and only make the loans they believe are most likely to get paid back.
First, let’s explore how banks work and how they make money.
As we discussed briefly above, banks are heavily regulated by several different sets of regulators. These regulators often pay attention to the all sides of a bank from the consumer side to the commercial side. Often, there are big fines or other actions taken by regulators if a bank isn’t following certain rules and regulations so this means banks tend to be conservative and certainly do not take risk that could put them in jeopardy of being out of favor with regulators.
Additionally, it’s important to understand how banks make money and the margins they typically operate from. As we all know, banks make money in a number of different ways, but primarily from making loans and earning interest. The money they make on interest is a function of the spread over the cost of funds, which is generally around 3% on a standard commercial loan for real estate for example. The fact that banks are heavily regulated and are only making about 3% on each loan they make certainly means they are not setup to take big risks and must evaluate each loan opportunity in a very thorough manner.
This also means a borrower must have their house in order as we discussed in “Getting Your House In Order, Part 1 of 3, Obtaining Financing For Your Volleyball Facility.”
Now, on to the language banks speak, which they expect you to be fluent in before presenting them with a loan request.
As a young banker, the first thing I learned was the 5 C’s of Credit, which is what banks look at and evaluate when considering virtually every loan opportunity. These 5 C’s of Credit are the language they speak and it’s mission critical to know what these C’s are before you go talk to a bank. The 5 C’s of Credit are Character, Capacity, Capital, Collateral and Conditions and we’ll explore each of these below.
Character
This one is very straightforward and deals with the character of individual or individuals applying for a loan (often referred to as credit). Character will be evaluated from a variety of different sources including what can be found online, within credit reporting agencies and through 1:1 interactions with the bank throughout the process. It also doesn’t hurt to have someone who is known and trusted refer you to the bank so your character will immediately be validated.
Capacity
Capacity generally deals with the borrower’s ability to repay the loan. In “Getting Your House In Order, Part 1,” we discussed the importance of having solid financial statements as those are the book a bank reads from and typically how they evaluate a borrower’s ability to repay the loan (often referred to as capacity). Capacity also deals with certain ratios that are very important to a bank like Leverage Ratio or Debt Service Ratio, both of which give insight into a borrower’s capacity to repay a loan.
Capital
Capital generally deals with the amount of equity a borrower has to put into a financing opportunity. For example, a bank will view a real estate loan that has 35% equity as a lot less risky than a loan that has 15% equity. The borrower willing and able to put 35% into a transaction, will generally obtain much better financing terms (rate, number of years to maturity, amortization, etc.) and will likely have an easier time obtaining the loan they are looking for.
Collateral
Collateral deals with the assets that are securing the loan and in the case of a volleyball facility we’re talking about the land and building where the facility is located. Collateral will always be evaluated based on a fair market appraisal and that is what the banks will use to determine things like the Leverage Ratio mentioned above.
Conditions
Last, conditions deal with the general economic environment that is present at the time. This could be the local market conditions as it relates to competition among volleyball clubs or it could be a more macro view on what the national or even global economy is doing at the time. For example, today’s local market conditions for volleyball clubs typically include intense competition for top athletes where clubs are extending offers knowing they will only have a certain percentage join the club. At the national or global level, small businesses like volleyball clubs are dealing with a changing local, state and federal tax landscape and the rising cost of college education, which is creating the club model as it exists today. All of these factors are important to understand because a bank will be looking to the club director for insight in making their loan decision.
This is high level overview of the 5 C’s of Credit, but more importantly provides some insight as to the language the banks speak. As a club director is evaluating everything outlined in “Getting Your House In Order, Part 1 of 3, Obtaining Financing For Your Volleyball Facility.” it’s very important to be ready to outline and communicate specifics related to the 5 C’s because this is the path a bank will follow in ultimately arriving at their decision to extend credit (a loan).
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About the Author
Allan is the father of three boys who are big time travel lacrosse players. He totally gets what club directors and parents face every day as we try to provide the best for our children. Allan is also a recovering banker so he grew up (professionally speaking) helping small businesses thrive!
