The federal reserve announced that bank credit has tightened. Not startling news, but the implications might catch small business owners by surprise.
The first impact is on new loans. Tighter credit standards means that banks will be even more conservative on business lending. Higher standards for cash flow, personal credit history, collateral requirements, and performance standards. Business loans that might have been approved a year ago, might no longer meet this new standards.
The second impact is on existing loans. This is where the surprise might hit hard on many small businesses. Many entrepreneurs assume that business loans work like personal loans -- you make your payments on time and the bank leaves you alone. Not true. Making payments on time is only one of several criteria that bankers will be watching. They will look hard at all of those loan covenants and performance expectations that many of us gloss over the the excitement of getting a loan for a new project.
During tight credit times, these restrictions become much more important for a bank to watch -- they are judged on how well they meet performance standards by the federal regulators. For example, a common condition is to maintain a certain debt coverage ratio, which measures how comfortably your cash flow covers your loan obligations. If you dip below the agreed upon ratio, the bank may step in and require you to improve your performance. If you don't, the bank can call your loan even if you never missed or were late with a payment.
The bank's portfolio of loans comes under tighter scrutiny during tough times like this, and they will pass that scrutiny along to their business loans.
Once a bank asks you to move your loan, you have to find another bank that will take on your loan. During good economic times, this is somewhat easier. But during times like these, all banks are under the gun to improve, so this becomes a much more difficult task.
Yet another reason to get back to basics during tough economic times. It becomes even more critical to improve cash flow and bring down debt.
