Assessing Bankability of a business ignoring industry characteristics – a fatal blunder
Never ignore the characteristics of the industry while starting new business and avail bank loan. The project that meets banker’s norms of lending is not necessarily a viable one.
I would like to narrate an interesting case where the bankers have accepted the project for funding but it failed due to factors mainly industry related which were not analysed before hand.
The entrepreneur is well educated and hard working. He had been steadily building his business in the service sector. Due to favourable turns in the industry fortune, he accumulated significant wealth over a long period.
Upon achieving success in one business, he started exploring opportunities for diversification as there was limited opportunity for expansion for his present business. As he was scanning for opportunities, he chanced upon an Airline industry veteran who had the lifelong association in the airline industry in different capacities and retired at a very senior level.
Over the year of interaction, they narrowed down to launch a new business in low-cost airline space.
The business model was built on the premise of starting with bank loan after pledging collateral and investing required minimum capital to start with, just enough to meet the bank’s requirement. They were expecting equity investment for expansion once the operation stabilized.
Bank was willing to extend the support since he had been a long standing customer of the bank and had met the lending benchmarks of financial ratios. Secondly, the exposure to the firm was adequately secured by the properties.
The firm launched operations only in two sectors from a metro initially to keep the cost low. They secured the air-crafts on the lease. Through media and publicity, the firm secured good visibility to attract potential passengers.
In order to ensure that they remain a preferred choice of service, the price of the ticket was kept at very low as is the case with any airline when they launch the business or start the operations in a new sector.
Everything was on as planned till they start experiencing liquidity problem to keep the air-crafts flying. The situation started aggravating. Their attempt gets equity investors on board was not yielding results. Investors were not enthused by the size of operations and duration in the business. In their view, the business needs to stay afloat and prove the sustainability of the model before they commit money.
The airline stopped the operations following huge losses and its failure to pay lease rentals to the aircraft lessors. The bank loan became due and marked for recovery. Pressing need to adhere to bank loan covenants made the matter worse.
However, it was resolved with taking over of the firm by another airline company.
Here the important point for analysis is- how the characteristics of the industry should be analysed before opting for a bank loan.
Industry Characteristics- an important ingredient in business planning:
We have discussed how important is understanding of the industry and its contribution to the success of entrepreneurship in our blog Industry Research: An important input for SMEs.
In the blog, we emphasized that industry within which a company operates is important to analyse the total risks the company exposed to.
To launch any new venture in any industry one need to be mindful of risks, clear roadmap to capitalise the opportunity and equally important is a clear understanding of funding required to stay afloat till new funds could be raised.
In respect of airline industry, it is widely observed that an entrepreneur should have proper funding arrangement of Rs 150 -200 crores before getting into airline business keeping in view the competitions, difficulties in stabilizing the operations etc. In the instant case, total money available is just a third.
Further industry characteristics do not mean to specify the funding alone. Every industry has its own unique set of challenges one needs to endure till the business become stable and can sustain itself. They may be certain regulatory restrictions in releasing the products that require one make provision for servicing the debt before the commercial operation starts. Recently one of my friends was explaining that if a new unit for tyre manufacturing is set up, it requires a considerable amount of time for testing the quality of tyre and there by securing regulatory approvals after readying the plant.
Whether bank funding can be treated as testimony to validity of business model?- Not always:
The company got a sanction of loan to start its operations with two air-crafts. However, the business did not sustain two years even.
The question is whether the bank is wrong in giving the sanction of loan to a project which did not mobilise required amount of money to make it sustainable(as it is the industry specific) before launching the operations?
This aspect is important because many entrepreneurs present sanction from bank to the project as a testimony to the validity of the business model. Many view that bank must have made all the required analysis before committing the loan to project.
In the instant case, such a notion proved wrong. Normally bank examines the proposal with reference to bank’s own benchmarks. It is very clear that proposal met the bank norms in terms of debt-equity ratio and other financial parameters. The loan was well secured by the collaterals. Bank did not dwell deep into industry characteristics (Read Insufficient arrangement of funding in the instant case).
As the norms have complied, bank sanctioned the loan.
Thorough understanding of industry characteristics is paramount to strategize entry into the new business. Taking cover under bank’s assessment as the vindication of viability is an incorrect approach for start-ups.