Sunday, May 26, 2024

Actions that damage your creditworthiness

Article written by Kiriinya Kithinji a financial services professional at WYLDE International.

Co-Op post

Most businesses will at some point in their existence require some form of financial accommodation from their bankers, whether by way of loans, overdrafts or if you are an importer, letters of credit.

Such facilities enable entrepreneurs to take advantage of the numerous growth opportunities when they appear.

A good relationship with your bankers could turn out to be an excellent asset that if well nurtured can support the growth of your business.

However, many Kenyan entrepreneurs are apt to forget this fact either because they view their relationships with their bankers as a necessary evil or because they do not understand that banks can be excellent potential partners.

To be sure, some of the negative attitudes to bankers are prompted by the well-documented predatory behaviors of some banks (or more accurately, their credit officers) that tend to focus too much on what they can gain from their customers while giving away as little as they can.

This fact probably explains why our MPs were all too happy to pass the interest rate capping Bill that the President signed into law in August 2016.

But to be fair to the banks, there is a huge number of successful businesses that have benefited immensely as a result of the support that their bankers have provided over the years.

Presumably, your business could also stand to benefit by building similar fruitful partnerships with your bankers. But where should you begin?

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If you expect to receive any meaningful financial support from a bank sometime in your entrepreneurship journey, then you need to begin to build your creditworthiness long before you apply for your facility.

A business is considered creditworthy if it has the current (and future) ability and inclination to honor its debt obligations as and when they become due.

From the bank’s perspective, your ability to pay its facility is mostly evidenced by the money that flows in and out of your bank account (otherwise known as account turnover) together with your books of accounts.

The better your account turnover, the greater the chances that you will have the money to settle your obligations when they fall due.

On a more fundamental level, your account turnover is one of the most reliable indicators of whether your business is doing well or not.

Healthy account turnovers usually indicate increasing or repeat buyers of your products or services, and more importantly, that your overall business skills are fit for purpose.

The truth is that it is unlikely that an entrepreneur with poor business skills will generate convincing account turnovers.

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On the other hand, your inclination to pay is primarily a character or reputation issue. If you have acquired a bad reputation for failing to pay your current or past facilities, you can be sure that few banks will look favorably on your latest loan application.

From our definition of creditworthiness above, we can extrapolate at least four broad categories of entrepreneurs.

The first group represents those entrepreneurs who have a demonstrable ability to pay and enjoy an excellent reputation for repaying all their past and current facilities.

By all accounts, such entrepreneurs are the banks’ ideal borrowing clients. If you belong to this category, then you are a creditworthy businessman, and this probably explains why your bank has been happy to support you with one facility after another over the years.

The second category of entrepreneurs represents those who can pay but have a bad reputation related to their failure to repay previous and current facilities.

The banks view such entrepreneurs as people with serious character flaws who cannot be trusted with further facilities.

If your business falls into this category, you have a next-to-zero creditworthiness score, and you need not look any further for evidence of this fact than the numerous times your facility requests have been turned down.

The third category represents those who have little ability to pay but enjoy a reputation as honest entrepreneurs.

Banks would be more inclined to listen to clients in this category compared to those in the second type. The reality, however, is that character alone is not enough to repay your facilities.

Money in the bank is what repays your loan installments, and if your business cannot generate enough money to meet your loan obligations, then you are not a creditworthy bank client.

Maybe the best your bank can do for you is to adjust the size of its facilities to suit your low ability to pay, but such small amounts are unlikely to benefit your business in any significant way.

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In my assessment, many startup companies tend to fall into the third category, which explains why the banks’ default response to facility requests from startups is usually a non-negotiable ‘no.’

The fourth group of business people is the greatest source of risk and trouble for banks. Entrepreneurs that fall in this category have neither the ability to pay nor the moral character that inclines them to pay any of their debts (whether owed to banks or other creditors).

If you fall into this category, likely, your business is already listed with the credit reference bureau as a bad debtor, and maybe your bankers (or your other creditors) have already commenced legal proceedings to recover their money or to sell the piece of land that you offered to secure your facilities.

My unsolicited advice to such entrepreneurs is that they should not even bother thinking about bank facilities. Their past and present actions speak loud enough about their below-par creditworthiness.

To illustrate the idea of creditworthiness further, take the example of the cafeteria owner who enjoys a steady flow of cash-paying clients who are attracted by her wide variety of African dishes, excellent location, and great service.

She has never borrowed from her bank since she opened her cafeteria, having financed her business from her savings after she left employment.

Her company has grown steadily, and she feels that she is now ready to leverage her growing brand to open a second but larger outlet within the town.

The major constraint to her vision is that the new cafeteria will require significant investments in kitchen equipment, furniture, goodwill, and working capital which far exceed the amount of money she has made so far from her existing cafeteria.

After spending some time weighing her funding options, the cafeteria owner concludes that the best option will be to get a loan from her bank.

Her main argument for pursuing this option is that her business began doing some fairly decent monthly turnovers barely two months after opening.

Also, she is more than willing to offer some prime plots worth millions of shillings as security for the loan.

The fact that her bank’s operations manager is a former high school classmate also gives her some measure of confidence that her loan application will be viewed in a favorable light.

A couple of days after she delivers her application, the cafeteria owner receives a call from her banker friend informing her that her application has been declined because she is listed as a bad debtor with the credit reference bureau.

The manager also discloses that the bank is not convinced that the cafeteria’s turnovers can support the repayment of the proposed facility.

In shock, the cafeteria owner protests that she has never failed to repay any loans that she took in the past and even makes the point that she cleared all her Sacco loans and employer-provided loans by the time she left employment.

Her banker friend calmly explains that since the cafeteria owner left work, she has fallen behind on her Higher Education Loans Board(HELB) loan repayments for over a year.

As a result, the management at HELB has listed her (and the amount she owes) as a bad debtor with the credit reference bureau.

The bank manager explains that the bureau listing implies that our cafeteria owner is a person who cannot be trusted to repay a loan and that the best way for the cafeteria owner to clear her name is to repay the outstanding balance owed to HELB in full.

As if this is not enough, her banker friend also reveals that the second reason why the loan application was declined was due to poor account turnover.

The cafeteria owner cannot make sense of this, because to the best of her knowledge, her business turnovers are more than capable of supporting the monthly repayments of the proposed facility, not to mention the fact that she has promised to provide her prime plot as security for the loan.

Firmly but gently, the bank manager explains to our cafeteria friend that there is no evidence from the bank’s perspective that her cafeteria has been doing well because the money she makes is rarely deposited into the bank account.

Also, the bank manager clarifies that her bank does not lend primarily based on the worth of the security provided to cover facilities, but based on account turnover.

The bank would be more than happy to provide an unsecured facility if only the account turnover is supportive.

Going back to our definition of creditworthiness, we can see that our cafeteria owner has failed the test.

First, she failed to demonstrate to the bank her ability to repay the proposed facility by failing to channel her daily sales through the account.

Indeed, it turns out on investigation that she hardly deposits any of the money that she makes from her current business.

Instead, she prefers to use the money from sales to fund whatever inputs she requires for the day-to-day running of her cafeteria. Whatever little money is left after paying for her inputs and wages is banked once in a long while.

Secondly, she failed the character test. Banks rely heavily on the repayment history of your previous facilities as a proxy for the quality of your character or honesty.

In other words, the banks treat your poor repayment record as evidence of a character flaw, even if as in the case of the cafeteria owner, you may have just forgotten to repay.

Also, our cafeteria friend’s outstanding student loan balance with HELB was treated as a red flag, even if it eventually turned out that the amount owed to HELB was not too significant.

Thirdly, the fact that you can offer some high-value property to secure your loan does not in itself automatically qualify you for a bank facility.

Nothing demonstrates this more than the reality that some local banks are happy to accommodate your facility requests based on consistent account turnover without asking for any security at all.

At any rate, the banks treat the security that you offer as a “fallback” source of loan repayment, knowing fully well that the real source of repayment funds must surely be the income that your business generates regularly.

And if your business skills and character do not measure up, it is unlikely that you will generate the high-quality turnovers that attract the attention of serious bankers.

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