Borrowing money is one of the most common sources of funding for a small business, but obtaining a loan isn't always easy. Before you approach a lender for a loan, it is a good idea to understand as much as you can about the factors the bank will evaluate when they consider your application. This page outlines some of the key factors a lender uses to analyze a potential borrower.
There are two types of financing: equity financing and debt financing. When looking for money, you must consider your company's debt-to-equity ratio. This ratio is the relation between dollars you've borrowed and dollars you've invested in your business. The more money owners have invested in their business, the easier it is to attract financing.
If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. That way you won't be over-leveraged to the point of jeopardizing your company's survival.
Equity financing (or equity capital) is money raised by a company in exchange for a share of ownership in the business. Ownership is represented by owning shares of stock outright or having the right to convert other financial instruments into stock. Equity financing allows a business to obtain funds without incurring debt, or without having to repay a specific amount of money at a particular time.
Most small or growth-stage businesses use limited equity financing. Equity often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues. The most common source of professional equity funding is venture capitalists. These are institutional risk takers and may be groups of wealthy individuals, government-assisted sources, or major financial institutions. Most specialize in one or a few closely related industries. The high-tech industry of California's Silicon Valley is a well-known example of venture capital investing.
Venture capitalists are often seen as deep-pocketed financial gurus looking for start-ups in which to invest their money. But they most often prefer three- to five-year-old companies with the potential to become major regional or national concerns and to return higher-than-average profits to their shareholders. Venture capitalists may scrutinize thousands of potential investments annually, but only invest in a handful. The possibility of a public stock offering is critical to venture capitalists. Quality management, a competitive or innovative advantage, and industry growth are also major concerns.
Debt financing means borrowing money that must be repaid over a period of time, usually with interest. Debt financing can be either short-term, with full repayment due in less than one year, or long-term, with repayment due over a period greater than one year. The lender does not gain an ownership interest in the business, and debt obligations are typically limited to repaying the loan with interest. Loans are often secured by some or all of the assets of the company. In addition, lenders commonly require the borrower's personal guarantee in case of default. This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the business.
Loans can be obtained from many different sources, including banks, savings and loans, credit unions, commercial finance companies, and SBA-guaranteed loans. State and local governments have developed many programs in recent years to encourage the growth of small businesses in recognition of their positive effects on the economy. Family members, friends, and former associates are all potential sources, especially when capital requirements are smaller.
Traditionally, banks have been the major source of small business funding. The principal role of banks has been as a short-term lender offering demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment. Banks generally have been reluctant to offer long-term loans to small firms. The SBA's guaranteed lending programs encourage banks and non-bank lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available. The SBA's programs have been an integral part of the success stories of thousands of firms nationally.
Ability to Repay
The ability (or capacity) to repay the funds you receive from a lender must be justified in your loan package. Banks want to see two sources of repayment—cash flow from the business as well as a secondary source such as collateral. The lender reviews the past financial statements of a business to analyze its cash flow.
Generally, banks feel most comfortable dealing with a business that has been in existence for a number of years because it has a financial track record. If the business has consistently made a profit and that profit can cover the payment of additional debt, it is likely that the loan will be approved. If however, the business is a start-up or has been operating marginally and now has a new opportunity to grow, it is necessary to prepare a thorough loan package with a detailed explanation addressing how the business will be able to repay the loan.
When a small business requests a loan, one of the first things a lender looks at is personal and business credit history. So before you even start the process of preparing a loan request, you want to make sure your credit is good.
Get your personal credit report from one of the credit bureaus, such as TransUnion, Equifax or Experian. You should initiate this step well in advance of seeking a loan. Personal credit reports may contain errors or be out of date, and it can take three to four weeks for errors to be corrected. It's up to you to see that corrections are made, so make sure you check regularly on progress. You want to make sure that when the lender pulls your credit report, all the errors have been corrected and your history is up to date.
Once you obtain your credit report, check to make sure that all personal information (your name, Social Security number and address) is correct. Then examine the rest of the report carefully. It contains a list of all the credit you obtained in the past (for example, for credit cards, mortgages, student loans), with information on how you paid that credit. Any item indicating that you have had a problem in paying will be toward the top of the list. These are the credits that may affect your ability to obtain a loan.
If you have been late by a month on an occasional payment, this probably will not adversely affect your credit. But it is likely that you will have difficulty in obtaining a loan if you are continuously late in paying your credit, have a credit that was never paid, have a judgment against you, or have declared bankruptcy in the last seven years.
A person may have a period of bad credit as a result of divorce, medical crisis, or some other significant event. If you can show that your credit was good before and after this event and that you have tried to pay back those debts incurred in the period of bad credit, you should be able to obtain a loan. It is best if you write an explanation of your credit problems and how you have rectified them, and attach this to your credit report in your loan package.
Each credit bureau has a slightly different way of presenting your credit information. For example, some use words rather than numbers. Good credits read "Never Late" or "Paid as Agreed." TransUnion uses number and letter combinations. "I" means installment credit, "R" means revolving credit. The key information is in the numbers. A "1" means perfect credit—you've always paid your bills on time. A "2" or "3" means you have been two- to three-months late in paying your bills. Too many of theses will hurt your chances in obtaining credit. A "9" means delinquency in paying your bills and a charge off. This could make it difficult to obtain a loan.
You can get specific information on how to read the report from each credit bureau. If you need help in interpreting or evaluating your credit report, ask your accountant or a friendly banker.
Don't be misled into thinking that a start-up business can obtain 100 percent financing through conventional or special loan programs. Financial institutions want to see a certain amount of equity in a business.
Equity can be built up through retained earnings or by the injection of cash from either the owner or investors. Most banks want to see that the total liabilities or debt of a business is not more than four times the amount of equity (in other words, when you divide total liabilities by equity, your answer should not be more than four). So if you want a loan, you must make sure that there is enough equity in the company to leverage that loan.
An owner usually must put some of her/his own money into the business to get a loan; the amount depends on the type of loan, purpose and terms. Most banks want the owner to put in at least 20 to 40 percent of the total request. For example, if a new business needs $100,000, the business owner must put $20,000 of his/her own money into the business as equity. The loan amount would be $80,000. The debt to equity ratio here is 4:1.
Having the right debt to equity ratio does not guarantee you'll get a loan. There are a number of other factors used to evaluate a business, such as net worth, which is the amount of equity in a business (often a combination of retained earnings and owner's equity).
When a financial institution gives a loan, it wants to make sure it will get its money back. That's why a lender usually requires a second source of repayment, called collateral. Collateral is personal and business assets that can be sold in case the cash generated by the small business isn't sufficient to repay the loan. Every loan program requires at least some collateral. If a potential borrower has no collateral, he/she will need a co-signer who has collateral to pledge. Otherwise it may be difficult to obtain a loan.
Collateral Coverage Ratio
The bank will calculate your collateral coverage ratio as part of the loan evaluation process. This ratio is calculated by dividing the total discounted collateral value by the total loan request.
Managerial expertise is a critical element in the success of any business. In fact, poor management is most frequently cited as the reason businesses fail. So lenders will be looking closely at your education and experience as well as that of your key managers.
If you'd like to strengthen your management skills, the SBA's Online Training offers a variety of free online courses that you can take on your own time and at your own pace.
Questions Your Lender Will Ask
Before you apply for a loan, you need to think about a variety of questions: