The Credit Process: A Guide For Small Business Owners
Introduction
Some say owning a home is the American dream. Millions of small business owners will argue, however, that owning one’s own business is really the American dream. But while it offers rewards, owning a business is not easy. Entrepreneurship has its problems, and a critical – and sometimes fatal – one for small businesses can be the lack of access to the financial resources to keep the dream going.
This text highlights information that prospective first-time borrowers need to know about the credit process before they apply for a loan.
Sources and Types of Funding
Where to Borrow.
Getting credit for a business can be a dilemma because until you’ve developed a good track record with business credit, many commercial banks and other traditional lenders will be reluctant to extend credit to you.
In order to identify the type of financial institution most likely to lend to your business, it’s helpful to pinpoint which of the four early stages of development your business is in.
Stages of a Developing Business.
– Stage one businesses are start-ups.
– Stage two businesses have business plans and product samples but no revenues.
– Stage three businesses have full business plans and pilot programs in place.
– Stage four businesses have been in operation for some time and have documented revenues and expenses.
Lenders suggest that rather than approaching a bank, owners of businesses in stages one and two should seek financing from informal investors. Such sources of funding may include friends or relatives, partners, local development corporations, state and local governments offering low-interest micro loans, private foundations offering program-related investments, credit unions featuring small business lending, and universities with targeted R&D funds.
Lenders say that businesses in stage four, and some in stage three, are sufficiently developed to approach a commercial bank or another traditional lender for a loan. If you intend to approach a commercial bank, lenders suggest that you first submit an application to a bank with which you have an established relationship. If you do not have an established relationship with a bank, lenders recommend that you ask an experienced accountant or lawyer to contact a bank and present your proposal.
Also, keep in mind that you must choose a legal designation – sole proprietorship, partnership, or corporation – and execute the necessary documentation for your small business before approaching a bank or another lender.
Reason to Borrow.
There are three major reasons why businesses borrow; the first and most common reason is to purchase assets. A loan to acquire assets could be for buying short-term, or current, assets – such as inventory – and would be repaid once the new inventory is converted into cash as it is sold to customers. Or, the funds could be for the addition of long-term, or fixed, assets, such as equipment.
The second reason is to replace other types of credit. For example, if your business is already up and running, it may be time to take out a bank loan to repay the money you borrowed from a relative. Or, you may wish to use the funds to pay suppliers more promptly to get a discount on the price of the merchandise.
The third reason is to replace equity. If you wish to buy a partner’s share in your business but you don’t have the cash to do it, you may consider borrowing.
Loan Types.
The purpose of your loan is critical in determining the type of loan you request. You also should make sure that the timing of the repayment schedule on your loan matches the incoming cash flow you will use to make the payments.
There are a number of loan types available to commercial borrowers, including lines of credit, seasonal commercial loans, installment loans, collateralized loans (which are secured with assets), credit card advances, and term loans.
Regardless of the type, most loans have the following features.
Common Loan Features.
– Loans are long term or short term.
– Interest rates vary depending on the term, type, size, and risk of the loan.
– Repayment may be a lump sum or on a monthly or quarterly schedule.
– Payments may be delayed until the funds help your business generate cash flow.
– The loan may be committed, meaning the bank agrees to lend to you under certain terms as you need funds without requiring you to re-apply each time.
– Some loans require that you maintain compensating balance levels in a deposit account.
Loan Agreements.
You also should be aware that the lender will expect you to agree to certain performance standards and restrictions in order to ensure that your business can repay the loan. These restrictions, known as covenants and warranties, commonly include the following:
– Maintenance of accurate records and financial statements
– Limits on total debt
– Restrictions on dividends or other payments to owners and/or investors
– Restrictions on additional capital expenditures
– Restrictions on sale of fixed assets
– Performance standards on financial ratios
– Current tax and insurance payments
The First Step: Preparing Your Business Plan and Loan Request.
When you apply for a business loan, you will need to provide certain information about yourself and your business in the form of a business plan. A business plan can act as an ongoing management guide to help you establish production goals and measure actual performance. Your business plan can help demonstrate to a prospective lender that you have the knowledge, managerial competence, and technical capability to run a successful business.
The Business Plan.
The business plan should include the following sections:
Title page.
Executive summary.
Company description.
Market analysis.
Products and services.
Operations.
Marketing plan.
Ownership.
Management and personnel.
Funds required and expected use.
Financial statements and projections.
Appendices/exhibits.
(See samples of detailed business plan in Exercise 4.).
What the Lender Will Review.
Credit Analysis.
Regardless of where you seek funding – from a bank, a local development corporation, or a relative – a prospective lender will review your creditworthiness. A complete and thoroughly documented loan request (including a business plan) will help the lender understand you and your business. The basic components of credit analysis, the «Five C’s», are described below to help you understand what the lender will look for.
The «Five C’s» of Credit Analysis.
Capacity to repayis the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Credit history is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.
Capitalis the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding .
Collateral or guarantees are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can’t repay the loan. A guarantee, on the other hand, is just that – someone else signs a guarantee document promising to repay the loan if you can’t. Some lenders may require such a guarantee in addition to collateral as security for a loan.
Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender also will consider the local economic climate and conditions both within your industry and in other industries that could affect your business.
Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience levels of your employees also will be taken into consideration.
Financial Analysis
In addition to the «Five C’s», a prospective lender will use four primary financial statements to make a credit decision.
A Personal Financial Statement.
Indicates your net worth. Each partner or stockholder owning a substantial percentage (for example, 20% or more) of the business should submit one. A personal financial statement is important to the lender, particularly if you have never received financing for your business before, because it gives the lender evidence of personal assets you could pledge to secure a loan.
A Balance Sheet.
Provides you with a snapshot of your business at a specific time, such as the end of the year. It keeps track of your company’s assets, or what the company owns (including its cash), and the company’s debts, or liabilities (generally loans from others). It also shows the capital, or equity, put into the business.
A Profit and Loss Statement.
Shows the profit or loss for the year. The profit and loss statement, also called the income statement, takes the sales for the business, subtracts the cost of goods sold, then subtracts other expenses.
A Statement of Cash Flows.
Presents the sources of cash in your business – from net income, new capital, or loan proceeds – versus uses of the cash, over a specified period of time.
It’s at this stage that you will appreciate having an effective accounting system. Without this system, you won’t know if you are profitable or not, let alone if you are liquid enough to pay for the next order of merchandise. A good system also will help you track your company’s growth and anticipate future cash needs.
Ratio Analysis.
Another tool the lender will use is financial ratio analysis. Ratios permit review of a company’s current financial performance versus that of previous years. An analysis of a company’s financial performance considers the status, changes, and relationships of critical components of a company’s health.
The lender also may use financial ratio analysis to consider how a company is doing when compared to another company. A limitation of such comparative analysis is that different industries are driven by different factors. As a result, the financial ratios of a manufacturer and retailer can be quite different even though both companies may be similarly successful.
Lenders are trained to appreciate both the benefits and limitations of ratio analysis and to consider financial results in the context of the company’s «peer group» of similar companies within its industry.
The following section presents some widely used ratios from four financial ratio categories: profitability, liquidity, leverage, and turnover. Your lender.’s analysis also may include ratios specific to your particular industry.
Profitability
Profit is the compensation an entrepreneur receives for the assumption of risk in a business venture. The profitable business must cover its overhead expenses and generate profits for its owner out of its «after-product-costs» cash.
Gross Profit Margin
One commonly used measure of profitability is gross profit, which is your sales minus your product costs. In ratio form, it is called the gross profit margin.
Operating Profit Margin
Another measure of your profitability is the operating profit margin. This is the core cash flow source that is expected to grow year to year as your business grows, and it excludes interest expense, taxes, and «extraordinary items» such as the sale of property or other assets. Higher profitability from one year to the next is generally considered a good sign for a company.
Liquidity.
How much cash does your business have on hand for immediate use?
