How do banks and lenders make their credit decisions? A 101 explanation.
Entrepreneurs and SMEs are the lifeblood of South Africa's economy. However, SMEs require financing to support their operations, expand, or weather difficult economic times. Banks are a major source of such financing. How do they decide whether or not to lend to an SME? Let's unpack the basics and see how one can become investment ready.
To start with, banks make a decision to lend you money based on their assessment of risks your business faces. Or said otherwise, based on the probability that you will repay (or not) the loan in time, in full. Their assessment typically involves evaluating several key factors, including the business's credit history, financial statements and financial projections, collateral, and very importantly for agribusinesses, your operational capability, assets and natural capital.
One of the first things a bank will look at is the company's credit history. This includes a record of the SME's previous borrowing and repayment behaviour, as well as any outstanding loans or overdue payments. A good credit history, with a track record of timely repayments and a low debt-to-income ratio, can increase the chances of the business being approved for a loan. On the other hand, a poor credit history, with a history of late payments or defaulting on loans, can make it difficult for the company to secure financing.
Secondly, banks will also assess the business's historical financial statements and projected financials. This includes examining the income, expenses, and overall financial health. The bank will look for (past, present and future) signs of financial stability and growth, such as consistent revenue and profit, low fixed costs, and a strong cash flow that demonstrates the ability of a business to repay monthly the loan.
A third important factor in many (but not all) lending decision is the collateral. This refers to the asset(s) that the company can offer as security for the loan. Collateral can include property, equipment, inventory, or other valuable assets that the bank can seize if the business fails to repay the loan. The value of the collateral will be considered in relation to the size of the loan, and the bank may require additional collateral if the loan is considered high-risk.
Finally, for agribusinesses, the bank will assess your operational capability, which is an entrepreneur's ability to produce according to best practices and deliver on their contractual commitments in time, in full, and on quality. This is also influenced by the assets (e.g., does the business possess the assets such as a tractor or harvester to farm at the planned scale?) and the natural capital (e.g., does your land size, soil, and the weather conditions permit growing the produce at the projected level of productivity and quality), which the bank will also assess.
Once all of these factors have been considered, the bank will decide whether or not to lend to the company. If the bank determines that the risk of lending to the business is low and the potential for repayment is strong, the loan may be approved.
👉 So how do I gear my business for investment readiness?
There are three areas we strongly recommend you tackle today to start your journey towards investment readiness:
- Compliance: ensure that your business is structured preferably as a private company, and is fully compliant with all CIPC, SARS, UIF and other legal requirements. Document your business's compliance by capturing your key documents on the pumpkn.io vault.
- Financial records: start building your digital records, by connecting your business bank accounts to pumpkn.io and reconciling your transactions. Employ an accountant to produce monthly your accounts and get them annually audited.
- Improve your financial health: as your financials transactions get recorded, keep a look out for pumpkn.io advices and insights to improve your financial health.
- Develop cautious, data-driven financial projections for your funding application: as you work on your financial projections, make sure to adopt conservative assumptions, such as for price, productivity, etc. Use pumpkn.io budgeting tools and get your projections tested with a pumpkn.io finance coach.