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Getting Your Small Business Investment Ready

Posted On Monday 1st May 2017 2:41 PM

Owner's Equity is rarely enough for running and growing a business. Every business owner thus aspires to make his or her business attractive for capital providers. Before approaching these capital providers, be they equity investors or lenders, it helps to do plenty of homework.

Capital providers undertake rigorous assessments of the business to ensure that their investment is protected. While there are a lot of commonalities in the criteria used by equity and debt providers, there are some aspects that one category focuses on more than the other. An equity provider will look less at liquidity and more at long-term growth prospects given the longer horizon. Strategic aspects of the business's product or service will also get more attention from equity investors. Debt providers meanwhile will have a hawk-eye focus on liquidity, short-medium term prospects, leverage levels, and promoter credibility. Let's look at the most critical aspects that a business owner needs focus on before approaching a lender.

To put it simply, any lender will focus on the '3 Cs': Character, Collateral, and Cash Flow.

Why is CIBIL so important?

CIBIL is a tangible proxy for the first 'C', Character.

Prior to 2006, lenders relied on their credit teams to perform detailed assessments of a business's creditworthiness. This was especially true for MSMEs, which typically did not have an independent credit rating.

CIBIL collects and maintains records of an individual's payments pertaining to loans and credit cards. Banks and NBFCs submit details to CIBIL on a monthly basis and these submissions are used to create Credit Information Reports (CIR) and credit scores. These scores are provided to credit institutions to help them evaluate credit worthiness.

The CIBIL score is the first data point reviewed by the lender. If the score is too low, the lender will probably not take the loan application further. If the score is in the comfort zone then further assessments will be carried out. Think of CIBIL as your first impression on the lender.

What are most important score determinants?

There are 4 major factors that affect your score

Payment history: Late payments or EMI defaults show you cannot sustain your present obligations. Be on time.

High credit limit utilization: If your loan and credit card limits are repeatedly maxed out then it is taken as a sign of indiscipline or financial stress. Keep an eye on limit utilization.

Higher percentage of unsecured loan: Having a balanced mix between secured loans (such as Loan Against Property) and unsecured loans (such as Personal loan, Credit Card) impacts scores positively.

Many new accounts opened recently: If you have opened multiple facilities in the recent past then lenders will assume that your financial burden has increased beyond tolerable levels.

Additionally, bear in mind that facilities that you have little direct control over like co-signed accounts, facilities where you are a guarantor, and joint accounts also affect your score. Review these carefully and regularly. Also, purchase and review your CIR periodically to avoid unpleasant surprises while making a loan application. As the saying goes, no point digging a well when there's a fire. These were the aspects relating to your first impression, i.e. CIBIL. Now let us look at some of the other crucial details that can make or break your loan application.

The Collateral

The second 'C', Collateral is the amount you put up as security for the facility. It could be in the form of machinery, property, or any other valuable asset. It can even be in the form of a cash fixed deposit you maintain with the lender. In the event of a default, the lender will liquidate the collateral against the amount due.

Lenders calculate a 'Loan to Value Ratio' for the purpose of determining adequacy of collateral. This is the total rupee amount of the loan divided by the lender's appraised value (not book value, not the value you declare) of the collateral. Most lenders will require this ratio to be upwards of say 1.2x or 1.3x so that there is enough margin of safety to ensure the lender doesn't suffer a loss if the collateral has to be liquidated in a hurry.

Important financial aspects

The third 'C', Cash Flows involves an assessment of the kind of liquidity (or cash) the business generates and whether this appears adequate to sustain the external borrowing. Basically, you should keep an eye on these ratios and compare with acceptable thresholds so that you are sure you are not applying for a loan amount higher than you can sustain.

Some of the most important financial ratios that are assessed by the lender's credit team include

Leverage Ratio - The leverage or debt: equity ratio is calculated by dividing sum of business loans by the owner's funds (equity + retained earnings). Acceptable thresholds differ between lenders and industries but it is always a good idea to keep this within 2x. This article explains leverage in more detail in the context of MSMEs.

Debt Service Coverage Ratio (DSCR) - This ratio is a simple indication of how much interest outgo the business's earning can sustain. Mathematically, it shows how many times annual interest is the annualised EBIT (Earnings Before Interest and Taxes). So while the Leverage Ratio shows the breathing room in the Balance Sheet, the DSCR is a measure of the breathing room in the Income Statement.

Current and Quick Ratio - These ratios measure the amount of Current (Inventory, Cash, Receivables, and other assets due within 1 year) and Quick (Inventory + Cash) Assets in relation to the Current Liabilities. These are a measure of short-term liquidity available in the business.

Margins or Profitability Ratios - Gross Margins, Operating Profit Margins, and Net Margins of the business are compared to similar businesses to indicate how profitable the loan applicant is.

So what are the measures to improve this particular 'C'? If you think that the present levels of your business may not meet the lender's threshold, you could consider: refinancing expensive debt, speedier collection of receivables, reducing inventory, maximising tax credit/shield, and optimising trade credit from suppliers.

Forewarned, as they say, is forearmed. Awareness of the credit appraisal process will help you to prepare documentation better, identify and remedy gaps, and anticipate information requests better. In itself, this ability will give your loan application a professional touch that will make any lender happy.

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