Corporate Finance

What lenders consider before granting a loan to a company

When a company is seeking loan finance, lenders will consider several factors. They will obviously be concerned with the return they receive, and ensuring that return is reasonable given the level of risk of default.
One way of remembering some of the main factors is the mnemonic PARTS:

Purpose
Amount
Repayment
Term
Security

1. Purpose: Loan to finance new businesses are likely to be risky. Lenders will be particularly careful to assess the business’s growth potential, strategy and the abilities of management to put their plans into effect. Borrowing to finance increases in working capital should normally be short-term and hence bank overdrafts be used; lenders will be very cautions of funding long-term substantial increases in working capital because of the scope offered for poor management.

2. Amount: The lender will wish to make sure that the amount that is being requested is a reasonable estimate of the amount the borrower will need. The lender will be concerned if the borrower is not asking for too much, or more than is needed for the particular purpose. This consideration is linked in with the customer’s wealth and ability to repay. The lender will also be concerned if the borrower appears to be asking for less than he or she really needs, and may need more later.

3. Repayment: The lender will want to ensure that the terms of repayment are clear and that the borrower will be able to obtain sufficient income to make the necessary repayments. The lender will therefore scour the borrowers’ financial statements for signs of problems such as declining profits, excessive gearing or poor control over working capital.

4. Term: Lender will consider whether the term of the loan is appropriate, and in particular, whether the term appears consistent with the timescale of the income stream that will be used to finance repayment.

5. Security: Lenders may ask for security, and will be concerned that the security is adequate. However, the likelihood that the advance will be repaid is the most important requirement for a loan. A lender is not likely to lend money to a person or business who has not got the resources to repay it with interest, even if it also has security for the loan. Security for the loan gives the lender the right to take certain assets if the borrower defaults. Security is only a safety net.