Note: This article originally appeared in the December 2010 issue of Franchising World.
The world of credit underwriting has been turned on its head, and unfortunately the franchisee is left holding the bag to figure out what lenders are looking for when approving credit in today’s challenging credit environment. If you are planning growth initiatives such as opening a new store, acquiring an existing operating store or remodeling your own store, it is likely that a large chunk of capital will come from some form of third-party financing. Does your company have the financial strength to obtain the capital needed? What do lenders look for when considering financial strength?
Lenders use financial ratios as a way to measure the financial strength of a business, and determining which ratios are used and how they are computed can vary greatly by lender and can become confusing. Following are five core areas that lenders evaluate to determine financing strength, along with simple “Underwriting Tips” to help you strengthen your financial position so that you can access the capital needed for your growth initiative.
1. Sales and Profitability
Gross sales (top line) are viewed closely by lenders to determine if sales are flat, growing or declining. Lenders will compare your company’s gross sales numbers to those across the franchise system to see if your company is over- or under-performing. A decline in sales is not seen positively by lenders because it may be an indication of poor management, or that cash within the business will continue to be drained to pay the company’s fixed costs, such as rent and salaries. Profitability (bottom line) must be a positive number; if not, then a lender will consider the financial strength of your business to be poor.
UNDERWRITING TIP: Most lenders will perform the lender “nod,” which means they will take a quick look at the top line (gross sales) and bottom line (profitability) to form an opinion on the strength of the company. If the top line shows declining numbers, be prepared to discuss with the lender why this is the case. If the location is experiencing issues that are causing the decline (i.e. construction, loss of a major anchor tenant), be sure to have a plan to address the issue and share that plan with the lender. If profitability is down or is not positive, be sure to figure out why before you apply for credit with a lender. Look at costs and expenses. Perhaps there is an opportunity to lower fixed costs by renegotiating the rent with the landlord or by lowering food costs through a co-op. If it is due to a one-time extraordinary event or if cost savings have been implemented recently which will positively impact future profitability, be sure to point that out to the lender.
2. Cash Flow
As the name implies, this means how much operating cash is flowing through your business. The lender will look at the amount of operating cash flow and compare it to how much debt must be paid back over the next 12 months (current debt). This is also referred to as the debt-service coverage ratio. If cash flow does not cover current debt (i.e. less than one times the amount), it indicates that addition capital is needed to pay existing bills. Needless to say, lenders do not like that. If the ratio is high, that tells the lender that not only can the customer pay back existing bills, but the customer can also pay them back on a new loan. This is a ratio where the higher the ratio the better.
Some lenders will add the current debt amount on the new contemplated loan to the existing current debt amount to make sure that the ratio is still over one times the amount (1.25 times or higher is a general rule of thumb). This provides the lender with a view that the company should have sufficient existing cash flow to service existing debt plus the proposed new debt without having to rely solely on new cash flow to cover the proposed new debt.
UNDERWRITING TIP: Know your debt service coverage ratio. If the ratio is less than one, confirm that the operating cash flow has been calculated properly by adding back all non-cash expense items (i.e. depreciation and amortization) and review current debt to identify any debt that is ending before 12 months, and point that out to the lender. If there is a shareholder loan that is causing the ratio to be calculated to less than one times the amount, then a subordination of the shareholder loan can be offered to the lender which will improve the debt service coverage ratio.
Inherently, growth initiatives are done to increase cash flow. If a remodeling project is expected to raise top line sales by a certain percent, which should increase cash flow, share that information with the lender. Provide the lender with a pro-forma financial statement on new store builds to show them what projected cash flow will be over the next one to two years. For acquisition deals, explain what costs and expenses will be saved through consolidated operations after the acquisition. In some cases you can ask the lender if it would consider refinancing all of your existing debt along with the new loan, which may have a positive impact on the company’s operating cash flow and the debt service coverage ratio.
Companies that are highly leveraged scare lenders.
At a basic level, this means how much debt your business has to how much equity you have in your business (debt-to-equity ratio). The lender wants to make sure that your business is not highly levered, which would mean that the debt of your business is two times or more higher than the equity you have in your business. Companies that are highly leveraged scare lenders because the company may not be able to pay back the loan even if there is just a small problem. Companies that are not highly leveraged provide the lender with comfort that the company is poised to weather the storm. This is a ratio where the lower the ratio the better. Understand that if your business is highly leveraged, a lender will consider the financing strength of your business to be poor, and you will be challenged with obtaining new capital for your growth initiative.
UNDERWRITING TIP: Know your debt-to-equity ratio. If the ratio is high, review all of your debt and be proactive in pointing out to the lender the amount of debt that is “rolling off” or if there is debt that you are going to refinance. If there is debt owed to you (or another stockholder), point out that the debt can be subordinated to the lender’s loan if that is an option (which means the lender will be paid back before you or the stockholder is paid back). If there is a complex reason why your equity is low or if you intend to infuse more equity into the business either personally or by taking on a financial partner or investor, point that out as well. If the ratio is low, that is good—keep it there.
4. Personal Credit
Personal credit is reviewed by the lender to evaluate how well the owner of the company pays personal bills. The basic notion is that an owner who has good personal credit is a better credit risk because it is an indication of how he will pay business bills. In addition, if the business bills are not paid, the lender can look to personal credit for payment. In the credit heyday, larger franchise operators may have become accustom to corporate-only transactions, where personal credit was not evaluated or needed. Today, don’t be surprised if personal credit is a requirement as part of the credit approval process for all owners of the business. Yes, the lender will evaluate the personal credit based on the credit score. However, be aware that most lenders will also evaluate the credit report beyond the credit score, looking for such information as the amount of revolving credit outstanding, the percent of revolving credit available, and the number of recent inquiries. In general, lenders will consider a credit score above 700 to be good, between 680 and 700 to be weak, between 650 and 680 to be risky and below 650 to be very high risk.
UNDERWRITING TIP: Obtain a copy of your credit report with your credit score before you apply for credit. If your credit score is below 700, do some research online to understand what you can do to improve your score. This generally involves paying your personal bills on time, but there could be errors on the credit report which are causing your score to be low. Know that a high-risk score is viewed unfavorably by lenders, so if there is an error on the report, such as tax liens or judgments which have been satisfied, but show up on the report as unpaid, point it out to the lender and be prepared to provide back-up proof. Be prepared to provide a co-signer or additional guarantor with strong credit, perhaps by a family member involved in running the business or the store manager if that person is in line to take over the store. Avoid applying for a loan with multiple parties, because each time your personal credit is reviewed, an inquiry appears on your credit report, and that affects your credit score.
Capital is available to fund growth for financially strong franchisees.
The lender needs to know what collateral is securing the transaction in the event of a default under the loan. In most franchise financing transactions, the collateral involves not only the equipment financed, but the lender also takes a first priority security interest in all assets located at the franchise store where the financing was provided. In many cases, a lender will require a lien against one or more existing stores to collateralize them for a loan made in connection with a growth initiative. If your growth initiative involves a remodeling project, be aware that an existing lien on the store may prohibit you from obtaining capital to remodel the store, since the lender’s collateral position will be secondary to the first lien holder. If you are acquiring a store or stores, the lender will want to ensure that there are no existing liens on the store, and if there are, that those liens are extinguished as part of the acquisition financing. Collateral can also come in the form of a letter of credit, pledge of a certificate of deposit, and cross-corporate guaranties.
UNDERWRITING TIP: Know what liens are on the store(s) that you currently own, as well as any stores that you are looking to acquire, and which lender has the lien. Use free and clear stores as leverage by offering additional collateral to the lender to obtain capital to fuel growth initiatives, and if applicable ask the lender upfront if it will agree to release its lien against the free and clear stores after perhaps half of the term is paid on time. Be careful not to allow one lender to become unduly over-collateralized by taking a lien against multiple stores where the financed amount is not warranted, as this will limit your ability to obtain capital to finance growth initiatives by offering an additional store as collateral.
Capital is available in the marketplace to fund growth initiatives for financially strong franchisees. The financial strength of your business is not only measured by the five areas that were covered, but also by pro-actively planning and communicating with the lender to address any of the areas where there may be weakness. Keep the financial strength of your business in check at all times, so when the right opportunity arises you will be able to quickly access capital to execute on the growth initiatives of your company.
Photo credit to Leonardni at http://www.sxc.hu/photo/1237498
|Eric Renaud is Senior Vice President of Portfolio Risk Management for Direct Capital Franchise Group, a national direct franchise lender providing financing to leading brands for new store development, remodels, acquisitions, equipment upgrades and more. He can be reached at 603-766-9373 or Erenaud@directcapital.com.|