Evaluating Small Business Risk

Posted on July 11, 2011  |  Written by John Ulzheimer

Small businesses understand that cash flow is their lifeblood.  And while it would be nice for the business to always generate positive cash flow, sometimes we need a little help to get through the ebb and flow of the business cycle.  Sometimes “cash flow” has to be borrowed.  The trouble is when you go looking for credit you’re not always sure how you’re creditor will interpret your risk as a small business borrower.  It’s important to understand that different creditors have different approaches.

When it comes to evaluating the risk of a small business there are a lot of differing opinions about which approach is best.  Some old school bankers prefer not to distinguish between a small loan and any other type of corporate loan.  Some retail bankers feel more comfortable focusing on the owners of the business as a kind of special consumer.

Lenders extending short-term credit are probably more comfortable relying on business credit bureau data, which details how the business has paid other businesses credit obligations in the past.  The truth is this…there’s no right answer. The method used for evaluating small business risk is mostly dependent on the purpose of the credit and, to some extent, the lender’s organizational risk culture.

Corporate Underwriting

In the days before credit scoring there was really no alternative to treating small business credit from any other kind of business credit.  And, in some schools of thought this is still the most appropriate method.  Corporate underwriting processes generally involve evaluating the risk of extending relatively large lines of credit (millions of dollars) to a business.  Think of capital equipment or machining plants - large investments that are required for the business to operate and grow.

Due to the size of the transaction and hence the resulting exposure to the institution, fairly extensive reviews and documentation are required for this kind of credit to be approved.  This would certainly include analysis of financial statements and assessment of the business’ viability but might also included things like collateral valuation.

Approvals are typically granted only after a presentation to a loan review committee.  All of these things require a certain amount of expertise and perhaps, more importantly, time and money.  The trouble starts when the same extensive reviews are required for the much smaller credit lines/loans that a small business might be looking for. 

Most industry credit-reporting for small business loans is done for transactions less than a million dollars.  And, the majority of reporting is less than a quarter of that with most being well below $100,000.  These are typically for things ranging from working lines of credit for inventory or parts to small pieces of equipment or even small IT investments.

Two factors make this type of underwriting for small business problematic – cost and competitive pressures.  At some point it becomes economically unfeasible to complete this kind of review for a small credit applications.  Just how small is going to vary from creditor to creditor but it’s hard to justify this kind of time and expense for a $10,000 equipment purchase, for example.
Additionally, if a competing lender is offering to do deal without all the hassle they’re going to stand a better chance of winning the business.  Some creditors will be okay with that, preferring not to deal in these types of smaller loans.  In their mind they’re more of a nuisance.

Of course this is all bad for small business.  This is at least in part why credit markets are so tight right now.  Creditors are trying to find a balance between being careful and providing solid returns.  Providing smaller lines of credit and loans to struggling small businesses requires a more streamlined, efficient decision-making process.  Many creditors just aren’t positioned organizationally to do that.  Everyone loses, especially the small business that’s desperate for a line of credit to help them make payroll.
Not that it’s all bad news.  Many creditors ranging from large financial institutions to small community banks are starting to figure it out.  Even credit unions are seeing an opportunity to gain market share that their big brother banks are ignoring, which is not unlike what’s happening in the consumer credit environment.