How do banks calculate business risk?

How do banks calculate risk
When a bank lends money to a customer, it takes the risk that the customer may not repay the money under the terms and conditions offered by the bank.  Just like you, banks are in business to make money, so they want to manage their risk as much as possible when lending money to a consumer. When providing finance to a business, they calculate risk based on various factors, and build that risk into the interest rate they charge.  So, how exactly does a bank calculate a business risk?

The business owner

That’s you. The bank will make an assessment about you, your background, your experience, and your business plan.  Ideally, banks prefer to deal with a business owner who has experience in the relevant industry.  If you’re new to the industry, the bank is likely to build in a risk factor on the interest rate to account for reduced experience and thereby increased risk.

Your Industry

Some industries are riskier than others. For example, a business that is seasonal in nature, for example tourism or agriculture, may have a more difficult time making repayments in the off season. Banks will want to know how you’ll manage your repayments when turnover is low.  Other industries, hospitality for example, have high staff turnover, require payment of penalty staff rates, and minimal client loyalty.  These issues make it difficult to make cashflow projections with any real degree of accuracy.

Security

When assessing business risk, the bank will consider what happens in the event you default on your business loan.  If your business loan is secured against property, the bank has a degree of surety that they will recover the loan balance from the secured property.  Alternatively, the bank may take security against the assets of the business.  The value of these assets can fluctuate, and therefore this option riskier than a loan secured by property.  As such, the bank will build this risk factor into the interest rate, and business loans secured by a charge over the assets of the business are more expensive than those secured by property.

The other option is an unsecured business loan.  This means the bank does not take security over any assets.  This is the riskiest option for the bank, and as such, unsecured loans are often the most expensive option.

How you Manage your Business Risk

Risk always goes hand in hand with return. Banks understand that. What they want to see is how you’re managing the risks that your business faces. This will vary depending on the type of industry you’re in, the amount of experience you have and your business processes.

If you or someone you know is thinking about applying for a business loan, get in touch with our team today.

Alex KempthorneHow do banks calculate business risk?