9 Chapter 8 – Commercial Credit

A corporation is a separate legal entity. It has the ability to enter into contracts in its name and be distinctly separated from its owners. Corporations can raise large amounts of capital more easily than a sole proprietor or partnership (Government of Canada, 2022). The process for setting up a corporation is expensive and complex. Entrepreneurs should work with an accountant and a corporate lawyer when establishing their corporation. In Canada, a corporation is created when one or more entrepreneurs register a business provincially or federally through the filing of the articles of incorporation. The articles of incorporation describe the business and its purposes and list the officers, directors, and the bylaws (bdc, 2022).

Corporations have unlimited lives and can, in theory, exist forever. When the owner dies, the company can continue on without issue. Owners’ personal assets are not at risk like they are in a sole proprietorship or partnership, and creditors can only seek payment from the assets of the corporation (bdc, 2022).

The main benefit of forming a corporation is the protection it provides from creditors; however, the costs to establish a corporation are often a hindrance to new, start-up business. Lenders need to be prepared to advise their clients on the best options and refer them to a corporate lawyer as needed.

Why do you need to know what a client’s business does? The lender needs to identify if there are possible restrictions on lending, applicable to certain types of businesses, due to the nature of the entity (government) or its level of risk (casino or amusement park). Plus, understanding what a business does may influence the loan structure.

Types of businesses include the following:

• manufacturing;
• wholesaling;
• retailing;
• service; and
• other (e.g., agriculture, mining, construction).

The type of business the client is involved in will impact the type of loan required, the level of risk, and the repayment schedule of the loan.

Commercial credit (or lending) is when a bank/financial institution lends funds to a business to help that business with its capital funding needs. In most cases, collateral is required (e.g., property or equipment) for commercial lending. Collateral helps to mitigate risk in the event a bank cannot collect if the business declares bankruptcy. Future cash flows from future accounts receivable can be taken as collateral if needed.

Commercial credit is contingent on the company’s viability. Banks want to see progression in a company’s long-term plans and feel confident that their debt will be repaid. Commercial lending often involves more parties and more signing authorities, and all have a say in the business and the taking on of debt. When a significant number of people are involved in the decision-making process for a business, there is often less personal contact between lender and client. The lender will need to determine the best contact method (the one also preferred by the client) so timely communication can occur. The entire process (from start to finish) of a commercial credit file can be lengthy. A lender needs to collect the information needed without having to go back to the client multiple times. Given that the lender will likely have less contact with the client, waiting for information can impede the entire loan process.

The structure of the debt in commercial lending could be lending a lump sum repaid in scheduled installments, and the debt is usually self-liquidating. Depending on the needs of the business, the term of the loan(s) could be short or long. Short-term funding needs could be for operational costs or to purchase equipment to facilitate business operations.

Step 1: Screen against loan policy. The lender needs to determine whether the request for capital is within the scope of the financial institution’s lending parameters. If the request is suitable and meets the parameters of the financial institution, the lender can continue.

Step 2: Gather data (e.g., financials, business plan, forecasts). The lender requests access to financial statements from the client; at a minimum, three years of statements are required. It is preferred that these statements are audited. Depending on the request, the lender may also ask for a business plan. A business plan helps the lender and financial institution determine how serious the business is about the request they are making. Financial forecasts are often requested. The financial institution is looking to see how this request for capital could potentially be realized and when the debt can be repaid.

Step 3: Analyze financial data. This involves a financial ratio analysis, which will be covered later in this chapter.

Step 4: Complete financial risk, management risk, and market risk assessments. These assessments are a continuation of the previous step but will often go further. They involve the lender interviewing key people within the organization.

Step 5: Build projections or analyze projections. The lender reviews the projections provided to check for accuracy. There are situations where the lender will be required to build projections.

Step 6: Identify risk mitigation strategies. The lender seeks out any risk concerns and determines the risk can be mitigated by collateral.

Step 7: Determine pricing. This varies from financial institution to financial institution. Usually, the lender and financial institution will consider the strength of the client, the assets being pledged as collateral, and the purpose of the request when they are determining pricing for the debt.

Commercial loans are often considered to be a short-term source of funding for business needs. Some financial institutions will offer renewable loans that may end up being extended indefinitely (Kenton, 2020). During the renewable period, the business is required to produce the needed documentation to ascertain their ability to continue carrying the debt load. Examples of these types of capital requests include the following:

• purchase of assets which will result in sales, then cash (i.e., machinery and equipment, a manufacturing plant, another company [assets are always taken as security]); and
• finance receivables (or inventory) to even out/bridge cash flow (accounts receivables or inventory is security).

The key is to identify the real reason the business needs the loan. The real reason is not always the reason given by the client. For example, a client requests a “working capital” loan to meet payroll. The lender investigates and finds that the problem is not a temporary cash shortage but is actually slow collections. The lender will need to find out why this is occurring and determine if it is on-going or temporary.

• Is there any policy restricting the stated loan purpose?
• Is the loan purpose to finance an illegal activity?
• What is the real loan purpose?
• How long is the trading cycle? Changed?
• What is the financing gap? (ACP + DSI – APP)

Should the borrower address these issues, the chances are that the loan would indeed be paid in record time.