How To Underwrite Soundly Small Business Loans Without Financial Statements

“How can I underwrite small business loans without financial statement analysis,” a bank CEO asked us recently. 

He was not seeking to be cavalier about risk, but acknowledging that financial statement analysis of a small business loan application under $75k, half of all business loan applications, is not reliable and adds a lot of cost to delivering the loan.  The bank’s underwriting process for such a loan typically followed the same steps as for a $750,000 loan.

Financial statements for small business applying for loans under $75k are frequently compilations out of programs like Quick Books, often using a modified cash basis of reporting and likely do not include comprehensive information.  Tax returns pulled can look little like the business financials 11 months later because of the volatility of small business activity.  Efforts to spread financials, calculate coverage ratios and underwriting successfully used for larger loans do little to diminish risk for these smaller loans and just add to expense.  As a result, these loans averaging $35k in outstandings are unprofitable.  How can FIs soundly and efficiently underwrite such small business loans for profitable relationships?

Many small business lenders have found a sound and profitable formula by analyzing the owner/guarantor’s credit score and the deposit cash flow, transactions and NSFs going through the checking accounts.

Credit scores have proven to be the most reliable predictor of loss according to research. Checking account activity of deposits can document cash-flow ability to repay a loan, along with NSF rate and tracking loan balance.  Loan covenants requiring checking accounts for small business loans with right of offset, provide sound underwriting and as well as automated credit monitoring.  As shown below, changes in the deposit level and owner/guarantor credit score alert repayment problem far before any indications from credit analysis or missed payments.  The chart below shows when deposits and guarantor credit score fell below minimums, the FI termed-out the loan before a loss could occur.  Credit monitoring for small business loans is greatly enhanced by the automated tracking and alerts shown below.

Losses may not be 75 bps, but efficiency in underwriting can offset higher losses to create a profitable overall business model.  A sample business model is below compared to manually produced small business loans.  Sound strategy for small business lending is requiring the checking account as well for monitoring, which doubles relationship profitability.

Manual vs Digital Lending with Guarantor Credit Score

 and Transaction Account Activity Underwriting Business Model

As a result, a growing number of financial institutions large and small shown below are underwriting small business loans digitally in real-time through automated analysis of owner/guarantor credit reports and checking account cash flow analysis.  Loans can be made efficiently and profitably with digital technology while also providing a superior customer experience of small business loans in minutes on a smart device.

Example Digital Lending Clients