If you turn to a commercial lender for a business loan, expect the focus to be on the company’s cash flow. In other words, the lender wants to know whether the business will be able to repay the loan from its profits and cash flow.
Lender’s view of value: ability to repay plus valuable collateral
Just in case this assumption does not work out, the lender will want the business owners to put up sufficient collateral – typically in the form of valuable business assets. Should the loan repayment become a problem, the lender will lay a claim on these assets.
Loan to value depends on how quickly the assets can be converted into cash
For a lender it is important to establish the marketability and values of the business assets pledged against the loan. The more easily the asset can be converted into cash, the higher the loan to value figure.
You can expect the bank to offer around 80% of the value of current accounts receivable. On the other hand, most lenders will likely offer just around 50% of the value of business furniture, fixtures and equipment (FF&E) assets.
Inventory is another business asset that the lenders scrutinize carefully. For a manufacturing company, the bank is likely to lend against the values of raw materials and finished goods inventory. In the event of default, the finished goods can be sold off to a jobber, while the raw materials usually can be returned to the supplier or sold at a discount to a competitor.
Since the bank is not in a position to complete the production, the work-in-progress inventory is usually not a good collateral.
Experienced lenders are well aware that some inventory may be slow moving. In the event of default, this type of inventory is much harder to convert into cash quickly.
Good inventory control records are very important if you are to get high loan to value figures for inventory. Writing off obsolete inventory has the additional advantages of reducing your property taxes and insurance costs.
Conservative commercial lenders are also likely to apply a haircut to inventory levels in excess of the industry average. The assumption here is that the business inventory value is likely overstated or partially unmarketable.
Business valuation results depend on the premise of value!
A major cause of disagreements between business owners and lenders is how the value of pledged business assets is determined. Business appraisal can be done under several premises of value. Depending on the choice of premise, the business valuation results and, therefore, the amount of business loan, can vary dramatically.
Lender’s position: liquidation premise of business value
Expect the lender to take a conservative position and use the so-called liquidation premise of business value. This establishes the worst case scenario in the event the business fails to repay the loan and the collateral needs to be liquidated quickly.
Business owners’ view: going concern
For the owners of a going concern business, the typical premise is value in use. The resulting business valuation is considerably higher than under the liquidation assumption.
Both the business owners and the lender are right. However, each party is viewing the business value from a very different perspective!