Jeff Judy

Jeff's Thoughts - February 25, 2015

Your Borrower's Need: Why vs. What For

One of the most basic questions in a credit application is "the purpose of the loan". Most borrowers don't have much trouble providing an answer to that question.

But this is a question that probably should mean something very different to the lending institution than it does to the prospective borrower.

What the borrower usually hears, no matter how you ask the question, is "What are you going to use these funds for?" The borrower is thinking in terms of obtaining credit to pursue a particular business task. That could mean investing in equipment or facilities, closing normal seasonal gaps between payables and receivables, or any other legitimate business purpose. It could be about fixing a problem or seizing an opportunity.

And don't get me wrong, that definition of "loan purpose" is important. Not only does it provide insights into the borrower's plans, needs, resources, and direction. The specific purpose of the credit provides the best basis for decisions about monitoring, and about collateral and other alternate sources of repayment. Good structure ties the means of detecting problems and the available responses to the intended use of the funds ... not least to make sure they are used as intended.

Still, you want to get at more than the "what for" of the credit. You want to get at the "why" of it, that is, you want to know why the borrower needs external funding. You need to understand why the borrower doesn't have the cash available to achieve the "purpose of the credit", to make the investment or to meet payables.

Sometimes it is just a matter of the usual business cycle. But sometimes the reason the borrower needs your help is a little more worrisome. Perhaps the borrower manages cash flow poorly. Do they not understand cash flow drivers? You can educate them. Or are they just too casual about collecting receivables, say? You can motivate them.

Are they buying that piece of equipment because it will contribute to enhanced revenue opportunities? Or did they try to skimp on maintenance and repair, to the point that their equipment gave up the ghost suddenly and now they have no choice but replacement?

As part of credit analysis, do your staff consistently get answers to both the "what for" and the "why" questions? Or are they too quick to accept any reasonable answer on the "Purpose of the Loan" line on the application?

External financing of business needs may be a very reasonable business strategy by the prospective borrower, or it may be an outcome of questionable management decisions along the way.

Woe to the financial institution that doesn't know which is the case!