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MGT601 - SME Management - Lecture Handout 20

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This lecture is dealing with the approach guide lines for approaching lenders. The lecture also explains the expectations of a lending institute from borrower.

How to Approach Lenders

You have explored all means to you to improve your liquidity. You believe you now need a short term credit from a bank to finance your trading activities. Your next step is to decide whom to approach. You should take this decision on the basis of financing sources available in Pakistan, how you rate their effectiveness and your own experience and affinities with these institutions. If cannot obtain the credit you need through them, because of the lack of resources or the weakness of the financial sector, it may be possible to you to reach overseas institutions. There are also private institutions that provide trade finance.
Talk to your banker or a financial advisor before you start negotiating with your customers or suppliers. Remember the working capital serves to pay for goods and services. The type or terms of credit you obtain from a bank should be closely linked to the method of payment you use to settle your creditor’s invoices, or that your customers or buyers use to pay you.

Your bank’s motivations will not be the same as yours. As a lender, it is interested in obtaining a good return on money lent, and it does not want to run the risk of not being paid. It will not went to spend time and effort discussing your needs, evaluating your company, assessing your transactions and advising you without an adequate fee for such services.

Your aim is to get the best possible advice on payment mechanisms and on the most appropriate related facilities; to obtain credit on firms you afford and to ensure that you are covered for all associated risks. You will want to look at all options. Your bank on the other hand, may want to solve your problem quickly, using techniques that are well known to its staff and that involve least effort and risk. You will want the bank to consider your trade transactions on merit, be your partner and share the risks with you. The bank may prefer to avoid losing time and may simply ask for changes on your fixed and current assets as security. On the other hand, your bank is in competition with other institutions. It will want to retain you as a customer if it considers you creditworthy and a good person or company to deal with, and if you offer good growth potential.

The following sections in this lecture will examine three aspects and show how the expectations of both the borrower and the lender can be reconciled.

Bank’s Lending Criteria

There are no standard criteria for short-term credit. Banks tend to set their own internal rules. Nevertheless, they are bound by general regulations and guidelines established by the state bank of Pakistan. There is usually a lending limit per customer. Banks are required to report any extra exposure to a customer or a group of related customer beyond 30% of its unimpaired capital. As per prudential regulations, the bank has to make sure also that the total accommodation availed by the borrower is not more than 10 times of the total capital and reserves (free f looses).

Another requirement set forth in the prudential regulations is that the debt equity ratio of the borrower may not exceed 60:40 and the ratio between current liabilities and current assets should not be less than 1:1. As per prudential regulations, the bank, as a matter of rule, should obtain copy of accounts of borrower related to the business, for analysis and record purpose. The requirement of the account is related to the amount of financing required.

Banks may sometimes invoke their lending criteria or statutory regulations as a pretext for not granting a facility to a borrower. There is nothing much you can do about this and in any case, it is unwise to insist on borrowing from an unwilling lender.

Your request for a short-term credit will have greater chances of success if you can satisfy the short-term lending criteria set out below.

  1. Good Cash Flow
    As a borrower, you must show that your performance is positive and that operations are not only profitable but also generate enough cash to cover all your commitments.
  2. Adequate Shareholder’s Funds
    In other words, you must not be already over committed to other lenders, but have a reasonable proportion of your own capital in the business.
  3. Adequate Security
    You will not obtain credit from a bank if all of your assets are pledged to other lenders.
  4. Expertise in Trading
    Most institutions like to know that you have a good record of successful trading. It is difficult to convince a banker to lend you money if you are a complete beginner, or if you’re a starting a completely different and new trading activity with untried products and unknown customers or suppliers in countries you have never dealt before.
  5. Good Reputation and Standing
    Your references and credentials must be acceptable to the lenders. They would no doubt find it difficult to convince their loan committee or board to approve an advance to a bankrupt company or a known crook! But, even assuming that your past is without blemish, it is helpful to have a backing of a reputable sponsor. This could be a well-known person in the business, your trade association or even your customer or supplier.
  6. Specific Purpose
    Although some lenders will be prepared to grant overdraft facilities on the basis of the security you offer, most institutions prefer to see their loans linked to specific transactions. In these cases, the transaction must be explained in full detail and shown to be profitable and self liquidating (the money borrowed will be repaid from the proceeds of the transactions to be financed).

Presenting Your Request for a Short-Term Loan

The way you approach a bank or other lending institution is all-important. Here are a few tips. Most are simply common sense ideas, and should always be guided by the elementary rules of the courtesy openness.

  1. Know whom you are dealing with
    Unless you are already institutions customers and know it well, find out all you can about the institution beforehand. Ask those who know it about their experience with the institution. Seek advice from your trade association, chamber of commerce, or association of industry. Try to obtain a copy of the institutions annual report and see what its affiliations are, and who its shareholders and directors are. Brochures and annual reports, are normally freely available in the banks and other institutions, tell you a great deal about their structure, organization and services. Banks should also indicate their lending rates and should give you their schedule of their charge and fees for services.
  2. Give prior notice of your intentions
    Always call up beforehand for an appointment or sometimes better still write a letter or a fax setting out briefly who you are and what you do (if the lender doesn’t know you well), how much need to borrow and why. Although you can conduct your transactions by correspondence, it is usually preferable to meet the person in charge of short-term commercial lending or trade finance. If the institution is far away or abroad, this will obviously be not possible, in which case you should be particularly careful about how to introduce yourself and what information you provide.
  3. Be Well Prepared
    Your banker is a busy person and you should come quickly to the point. State who you are, what you do, how much money you need and what you need it for. Be prepared to handover a copy of your annual report or your financial statements (balance sheet, profit and loss account, budget etc.) as well as a brochure on your company’s activities or products. Always make a point of stating clearly of what you intend to do with the funds you want to borrow. If your intention is to finance the purchase of goods or services essential for manufacturing products for export, tell your banker the whole story; whom your are buying from, whom you are selling to, how you intend to pay and get paid. It is always wise to speak to our bank about these matters before you sign contracts or agreements with your suppliers or customers or make payment arrangements.
  4. Seek Advice:
    Experienced bankers can guide you and advise you on the risks and dangers of various payment methods, on the most suitable way to finance your transactions and on the security you should provide as a guarantee for your borrowings. You should also remember to ask about hedging possibilities to cover or reduce risks of currency and price fluctuations.
  5. But Be Cautious:
    Resist borrowing more than you need, or for too long, or at a too high interest rate. Banks sometimes propose kinds of credits or payment methods that they are most familiar with, or that are the most to themselves or that present the least risk to them. Ask about the costs. Remember there are costs, fees, and charges in addition to the interest rate. What about front-end fees? (These are payments deduced from the loan at disbursement to cover the lender’s cost of evaluating your request, assessing the risk or opening the loan account). What are the back-office fees? On each disbursement, for instance? If the bank to purchase foreign exchange or to open a documentary credit applies the advance, how much will it cost?
    Most institutions have standard or sliding scale rates for their services. Never hesitate to ask for a copy and seek guidance on how these rates will effect your transactions. If there are to be legal costs, such as lawyer’s fees for drafting a loan contract or registering a charge on assets or a debenture, you should obtain clarification on these matters before committing yourself to any obligation.
  6. While Avoiding “shopping around”
    Bankers will not like the idea of your shopping around for the best deal, visiting several institutions and making comparisons between them. If you tell them that you have found a better deal elsewhere after they have spent hours with you, drawn up documentation and obtained clearance from their loan committee, senior management or board, they will feel that you have wasted their time.

There is in fact nothing wrong in trying to get to know the banking sector and wanting the best deal. But you should avoid giving the impression that you are also talking to others after negotiations have reached the stage where the agreement is virtually finalized and awaiting management or board approval. The success of a good borrower-lender is built largely on trust. Trust is developed over time and is a result of a positive experience. The banker will often prefer to try out a prospective customer by offering small, well secured loans on a very short-term basis to see how it works. S transactions are successfully repeated, the customer’s standing rises and his or her credit improves. When you approach an institution for the first time, bear this in mind. The cheapest lender may not in the long run, rove the best.

Book Recommended

How to approach Banks By ITC/SMEDA

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