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 making you a loan. The U.S. Small Business Administration offers the following key points to consider:
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 and 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.
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. Before you go to the bank or even start the process of preparing a loan request, you want to make sure that your credit is good. First, get your personal credit report by calling TransUnion, Equifax, TRW or another credit bureau. It is important to initiate this step well in advance of seeking a loan. Personal credit reports may contain errors or be out-of-date. It can take three to four weeks for this error to be corrected and it is up to you to see that this happens. You want to make sure that when the bank pulls your credit report that all the errors have been corrected and your history is up-to-date.
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 not more than four times the amount of equity. (Or, stated differently, when you divide total liabilities by equity, your answer should not be more than four.) Therefore, if you want a loan you must 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 percent financing through conventional or special loan programs. A business owner usually must 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 percent to 40 percent of the total request.
Collateral. Financial institutions are looking for a second source of repayment, which often is collateral. Collateral are those personal and business assets that can be sold to pay back the loan. Every loan program, even many micro-loan 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. 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.
Experience. Bankers want to know that those who are involved in running your business have experience in the specific sector. If you have no such experience, you should not approach a bank, let alone start the business, unless you plan to hire people who know the business or to take on a partner with the appropriate experience. Even so, you should take some time to work in the business first and take some entrepreneurial training classes.
By Salome Kilkenny