Uncovering the mysteries of commercial banking

On the Money
From the  April 5, 2002 print edition

here are over 100 distinct commercial banks in the Denver metropolitan area, not counting branches or automated facilities. Even though many view banks as some omnipotent and mysterious source of all funds, small business owners often turn to banks as the first potential source of new money. What all banks have in common is their simplicity: they are merely balance sheets upon which appear its assets and liabilities. Savvy small business owners should want their companies on that list of assets. Small businesses that use traditional commercial bank financing are in fact an asset of that bank.

Persuading your banker of the worth of that asset can be a frustrating and baffling process. Cultivating relationships with bankers, speaking their language, and understanding the process of loan negotiation are critical elements of successful small business ownership.

Smart small business owners will acquire access to all of the commercial banks in their area, and then analyze each one. Minimally, the analyses should include these critical ratios: 1) Loans to Deposits, 2) Liquidity Ratio, and 3) Capital Ratio. These ratios provide an indication of the bank’s receptiveness to making new loans. Further, understanding the ratios will help develop an approach that is consistent with the bank’s current financial condition and temperament.

1. Loans-to-Deposits Ratio

This ratio is calculated by dividing loans by deposits. The average for most banks is 75 percent. The lower this ratio, the more conservative the bank’s attitude generally is toward lending.

2. Liquidity Ratio

The liquidity ratio is calculated by adding cash, federal funds sold, U.S. government securities, and 70 percent of state and municipal securities. This sum yields the bank’s total liquid assets. To determine the liquidity ratio, divide liquid assets by total deposits. A representative (Denver) commercial bank has a liquidity ratio of about 35 percent. Typically, the lower this ratio, the more aggressive the bank’s position toward making new loans (i.e., the more likely the bank is to lend money).

3. Capital Ratio

The capital ratio is determined by dividing the sum of capital, surplus, and undivided profits by the total deposits. This ratio is often between 5 and 7 percent, and the representative (Denver) bank has a capital ratio of 8 percent. The lower this ratio, the more aggressive and therefore the more receptive the bank may be toward lending.

Although these three ratios provide a general indication of the bank’s relative conservatism or aggressiveness, other components should be considered as well-most of them available in the bank’s annual report.

The chairman’s opening letter in the bank’s annual report, for example, is often a particularly revealing indication of the bank’s lending posture. In narrative form, the message presents the bank’s overall results of the past year and, more importantly, outlines the bank’s position and strategies for the future. Keep in mind that these letters are written for shareholders and will attempt to keep that group comfortable with the bank’s intentions.

A more detailed and insightful analysis may be performed using information found in the bank’s Supplemental Schedules and Notes to the Financial Statements.

Items that should be monitored and analyzed include:

Allowance for Loan Losses, a measure of the institution’s pessimism or optimism

Loan Analysis by Category, commercial, construction, real estate, installment, etc.

Off Balance Sheet Financial Instruments, a measure of responsiveness and flexibility; recently, this could also be an enormous warning signal that will require additional analysis

Legal Proceedings, not always bad, as it may indicate the protection of assets

Problem Assets, many real estate loans of the mid-1990s may be found here, also many failed telecommunication companies (Need some cheap routers?)

Loan Concentration by Industry, which usually contains a category for commercial real estate along with manufacturing, high technology, etc.

Loan Concentration by Collateral Type, which usually contains real estate types (construction, land, etc.) The most important is the distinction between “hard” and “paper” assets.

Foreclosed Real Estate, which gives an indication of the bank’s history with real estate lending and their aggressiveness in collections

Loan Loss Experience, an indication of past experience and therefore a measurement of willingness to lend in a particular area

Using a database to store and access data on multiple banks, small business owners create access to powerful information that will help determine which institutions are likely to be the most receptive to their individual needs. For example, a small business owner might request a list of banks with loans-to-deposits greater than 70 percent, a declining loan loss experience in undeveloped land, and less than 30 percent of their loans in commercial real estate. The resulting register of institutions provides a solid starting point for the small business to obtain financing.

Identifying a bank based solely on financial or statistical information is just the beginning. Behind and within every organization, including banks, people make the decisions. Knowing and developing a genuine rapport with the parties of the transaction greatly improve the probability of success- for you as well as for the banker.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.