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 your banker 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 request.
Show me the money… Ability to Repay/Capacity
The ability to repay must be justified in your loan package. Banks want to see two sources of repayment -- cash flow from the business, plus a secondary source such as collateral. In order to analyze the cash flow of the business, the lender will review the business's past financial statements. Generally, banks feel most comfortable dealing with a business that has been in existence for a number of years because they have a financial track record. If the business has consistently made a profit and that profit can cover the payment of additional debt, then it is likely that the loan will be approved. If however, the business has been operating marginally and now has a new opportunity to grow or if that business is a start-up, then it is necessary to prepare a thorough loan package with detailed explanation addressing how the business will be able to repay the loan.
Yes, Virginia, your personal credit matters… Credit History
One of the first things a bank will determine when a person/business requests a loan is whether their personal and business credit is good. Therefore, before you go to the bank, or even start the process of preparing a loan request, you want to make sure your credit is good.
Skin in the Game… Equity
Financial institutions want to see a certain amount of equity in a business. Equity can be built up in a business through retained earnings or 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 no more than 4 times the amount of equity. (In other words, when you divide total liabilities by equity, your answer should no greater than 4.) To receive a loan, you must first ensure that there is enough equity in the company to leverage that loan.
Don't be misled into thinking that start-up businesses can obtain 100% financing through conventional or special loan programs. It is common for business owners to put some of her/his own money into the business. The amount an individual must put into the business in order to obtain a loan is dependent on the type of loan, purpose and terms. For example, most banks want the owner to put in at least 20 - 40% of the total request.
Oops, now what?… Collateral
Financial institutions seek a second source of repayment, which often is collateral. Collateral are personal and business assets that can be sold to pay back the loan. Every loan program, even many microloan programs, requires at least some collateral to secure a loan. If a potential borrower has no collateral to secure a loan, she/he will need a co-signer that has collateral to pledge. Otherwise, it may be difficult to obtain a loan.
And remember, the value of collateral is not based on the market value. It is discounted to take into account the value that would be lost if the assets had to be liquidated.
Who’ s steering the ship?… Experience
Ultimately, a business can only be as successful as the weakest member of its management team. An entrepreneur that owns or wants to open a business and has no experience in that business should not seek financing, let alone start the business, unless they intend to hire people who know the business or plan to take on a partner that has appropriate experience.
Understanding the evaluation criteria is only one step in securing financing for your business. There are additional measures to take to become prepared.
Review, refine, and revise your business plan. Does it provide answers to common questions your lenders will ask?
Carefully select a bank; it is just as important as choosing a member to join your management team.
Realize that sometimes businesses need help. SBA's loan programs may be able to assist your business in obtaining financing.
*SBA's participation in this blog does not constitute an endorsement of the William E. Simon Graduate School of Business Administration or any other person or entity. SBA's programs and services are provided to the public on a non-discriminatory basis.
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