Jeff Judy

Jeff's Thoughts - November 9 , 2011

Why Are You Making That Loan?

Discussions of creditworthiness, loan write ups and approvers' questions all tend to use the word "purpose" a lot. What is the purpose of the loan? Are the sources of repayment appropriately linked to the purpose?Do we have covenants and monitoring in place to make sure the funds we lend the borrower are actually applied to the stated purpose?

"Purpose" is a word I'd like to demote, in credit analysis. "Purpose" is a borrower's word. It answers the question, "What is the borrower going to use the money for?"

That's good to know, and we should take steps to make sure the borrower uses the credit for the purpose they stated when they made the request.

But this "purpose" does not answer the question, "Why does the borrower really the need money?" Purpose tells us what the borrower wants to do with the money, but it does not tell us the all-important cause of the shortfall.

After all, such shortfalls are why we are in the credit business. Every credit provides cash to enable a business to do something it does not have the funds to do itself.

Let's say the "purpose" of the loan is to make payroll. Your customer is a highly seasonal business, and they have a credit line with your bank. That seasonality, the timing between marketing and delivering the product and receiving payment, is the cause of the credit need. Predictably, at the same time of year every year, they need some help paying the sales and manufacturing employees who generate and fill the orders that bring in more than enough revenue, later in the cycle, to pay down the line and produce a profit for the company.

Reminds me of client I had some years ago who had a line with my bank at the time. They called me because they saw a shortfall in the coming month, and their need was greater than the untapped funds they had remaining in their line.

When I went out to the company to ask the borrower why they needed more credit, they said it was "to make payroll" that month. The "purpose" was clear, as far as they were concerned.

But while I was there, I noticed a large piece of equipment sitting idle in the corner. Turns out that the equipment was a "great deal," recently paid for in cash. The borrower had siphoned off a significant amount of cash from the business without looking down the road to see what problems that would create.

The immediate problem was payroll, but the cause of the problem was a bad financial management decision by the borrower. (And, by the way, I did not increase the line.)

It is important, certainly, to know what your borrower plans to use the money for. It is equally important to make sure they do what they say, that they do not divert funds they obtaine ostensibly to make payroll, or buy equipment, into redecorating executive offices.

But if all you know about the reason the customer is borrowing from you is what that customer tells you, you are probably in for some ugly surprises in your portfolio.