What banks see in your business that you don't

As a commercial finance advisor I see a lot of great businesses. I am continually surprised however by how little people know about what a bank looks at when assessing a loan, and why banks don't tell more people about it. The surprise extends when more often than not these great businesses look ordinary as banking propositions.

The major cause of this misunderstanding is that business does not look at cashflow the way a bank looks at it. If more businesses did look at it this way, more directors would sleep better at night and would grow at the rates that the quality of the product/service deserves.

So what is a quick way to tell if the way you manage cash is attractive to banks? You need 2 ratios:
1) The Gross Margin %
2) The Working Capital %

The Gross Margin % is simply the amount of money left over after you pay your trade suppliers - ie Gross Margin / Revenue x 100. What this percentage shows is how many cents you have left after paying suppliers, for every $1 of revenue. Hence if your Gross Margin % is 38%, then for every $1 of sales you keep $0.38 of gross margin (ie before you pay your operating expenses but after you've paid your COGs.

The Working Capital % shows you how much money you need to run your working capital machine. Working capital is made up of your Debtors, your inventory and your accounts payable/ trade creditors. It is calculated as (Debtors + Inventory - Accounts Payable)/Revenue x 100. What this signifies, in simple terms, is how many cents for every $1 of revenue are used up by your business in the funding of debtors, inventory and creditors.

An alarm bell rings for a bank when Working Capital % is greater than Gross Margin %. Why? Lets go back to the previous example. Gross Margin % is $0.38 for every $1 of sales. If Working Capital % is say 43%, then the business requires $0.43 to fund the business for every $1 of sales. So when $1 is made in sales, the business has $0.38 left after COGs, and yet it still needs $0.43 to fund the business, so from a cash perspective it is using $1.05 when it has only earned $1. And this is before it pays for operating costs.

From this you see that whilst the business might record a profit for tax purposes, for bank prposes it is going backwards, and one day it will just run out of cash. This is one of the first things a bank looks for. To fix it, well that's for another day, but feel free to contact me and I can talk you through it.