Loans (Photo credit: jferzoco)
As a business owner, you’ve probably heard that tired old line “Banks only lend to businesses that don’t need a loan.” At times you might have even believed this to be true. Yet businesses still borrow money from banks, which begs the question: Why would a business borrow money if it didn’t need a loan? There is a very simple answer to this question: Businesses borrow money because they need the cash to achieve a predetermined goal. That goal might be to purchase a building, another business, or even a piece of equipment. Perhaps it is a line of credit to supplement cash flow depending upon a variety of factors. The simple truth is that a loan is a tool (and not the only one) that helps a business with its cash position.
So if cash is so important, how do banks assess financial risk? In other words, how do banks determine which businesses to lend to? The answer is complicated as there are a wide variety of factors that must be included in the lending decision. The goal of the bank is to assess the likelihood that the borrower will repay the loan in cash as scheduled.
There are two basic considerations that a bank must assess when underwriting a business loan: liquidity and solvency. If a business is both liquid and solvent this does not mean the loan is approved (again, there are several other factors which must be considered in the approval process); however, a business that does not demonstrate sufficient liquidity and/or solvency might not be in a good position to borrow (as they might not be able to document their ability to repay the loan as scheduled).
Liquidity refers to a business having sufficient cash flow from internal operations to repay the loan as agreed. Repaying the loan refers to both paying interest and amortizing debt. Solvency refers to the ability to generate cash from other sources (not from internal operations). This is most often from the sale of assets. Since this is not generally considered an “ordinary” source of cash, banks often look at cash generated in this manner as “extraordinary income” when analyzing the financial statements. In other words, this is cash generated outside of ordinary operations (Moody’s Risk Management Services, 1998).
When a borrower is both liquid and solvent, it makes sense to continue the loan process. Conversely, if a borrower is neither liquid nor solvent, they essentially lack the ability to repay the loan. In either of these two scenarios, a bank has a fairly easy decision as to proceed or not.
When a borrower is liquid but not solvent (in other words, they have sufficient cash flow to repay the loan, but lack the ability to generate cash through the sale of company assets) most banks will continue to assess the creditworthiness of the business coupled with their specific request. However, when a business is solvent, but not liquid (cannot repay the loan through cash flow from operations, but has assets it could potentially sell to generate cash to repay the loan) it is more difficult for a bank to determine the likelihood that the borrower will be able to repay the loan as scheduled (Moody’s Risk Management Services, 1998).
Liquidity and Solvency are just two of the considerations that banks must assess in reviewing a loan request for a business. Understanding these two topics is very important to any business owner because a liquid, solvent business is not only the type that banks want to lend to, they are also the types of businesses that are being successful in generating cash, which is the goal of a for-profit organization.
Moody’s Risk Management Services. (1998). Understanding financial statements (6th ed.). Walnut Creek, CA: Moody’s Risk Management Services, Inc..
