The 5 Keys to Getting a Small Business Loan


Image source: Images Money.

When your business needs money, going to your local bank and applying for a loan can be pretty stressful. Unlike mortgage loans, where banks have clear-cut standards for loan approval, a business loan is just as much art as it is science.

Whether your business needs cash to buy a new facility, new equipment, or simply to fund growth, these five concepts are the key to getting your loan approved. 

1. Character
This may seem really obvious, but it's more often than not the most critical factor in your loan approval. If the bank doesn't think you have the character to pay back your loan, then they will not approve it. Plain and simple.

Banks assess character through a variety of methods. They'll look at your personal credit history, and many times, they'll review your business' credit history. In some cases, banks will want to talk with your suppliers and other business partners, as well.

The point of all this background work is to learn how you've handled your obligations in the past. History tends to repeat itself. If you pay your bills on time and conduct business ethically, then you have nothing to worry about. That said, it's still worth it to check your credit report at AnnualCreditReport.com to ensure it's accurate.

2. Cash flow
Loans are repaid with cash. Not profits. Not growth. Not inventory. It takes cold, hard currency to pay your principal and interest. As such, banks care a whole lot about cash flow.

To banks, cash flow boils down to cash in versus cash out. That means it's not only about your business' sales, expenses, and profits, but also its inventory management, its account payables, and receivables.

If your business sells a lot of products at Christmas time, that means you'll be spending lots of cash in the fall to build up your inventory to prepare for those seasonal sales. Do you have the cash flow to make your payments in addition to all that investment in your inventory?

For both you, the business owner, and the bank, cash is king. If you want the loan approval, prove to the bank that you understand cash flow and that you're business has the cash flow to repay the loan.

Image source: Images Money.

3. Capital -- the back up plan
Banks are in the business of risk and, therefore, they will always want a back-up plan. That means that your business should have enough cash held on the balance sheet in case of a short-term hiccup in your cash flow. 

Further, the bank will want your business to have a low to reasonable level of debt relative to the company's capital. The higher the ratio of your debt to your net worth, the bigger the risk, and the less likely your loan gets approved.

Think of this like you would if you were applying for a mortgage loan. The bank wants to ensure you have sufficient cash and net worth to ensure you can make a down payment, and also have enough in reserves in case of a financial hardship.

If your business distributes its extra capital every year for tax purposes, the bank may require you to personally guarantee the loan. The key to understand is that having strong cash flow is, by itself, not enough. There needs to be a back-up plan.

4. Collateral
The bank will typically require collateral for the small business loan. Most often, the collateral will correspond to the purpose of the loan. If you are buying a new facility, expect the bank to require that property as collateral. The bank can require equipment, inventory, accounts receivable, or sometimes, even all the business' assets as collateral.

Again, this requirement is very similar to the home mortgage process. The collateral is the back-up plan to the back-up plan. If your cash flow, cash, and net worth all are unable to repay the debt, you can always sell the collateral. 

5. The terms of the loan
This may be the most overlooked consideration in determining if your loan is approved or denied. Of course, if you request a loan with a 0% interest rate and a 100-year term, that will be denied. However, there are other more subtle concepts that could prevent approval.

Let's go back to our Christmas sales example from above. Let's say you request a five-year loan with fixed monthly payments for the purpose of buying inventory solely for this year's Christmas season. As proposed, that loan will be denied.

Image source; Images Money

Why? Because you should have the cash to pay the loan back as soon as Christmas is over this year. You've sold all that extra inventory. The loan terms need to match the loan's purpose and, in this case, that purpose is very short term.

Let's quickly run through another example. Let's say you need to purchase a new delivery truck that you expect will work for five years. If you request a 15-year loan to pay back that debt, that loan would be denied. Why? Because after just five years, that loan would no longer have value to you, and you'd still have 10 more years before you paid off the debt. 

Before you apply for your loan, ask a few local bankers for advice on the best way to structure your debt based on your needs. That will go a long way to making the bank happy, and also making your business stronger.

Banks want to make the loan -- make it easy for them
Richard Fischer, President of the Dallas Federal Reserve Bank, spoke with the Wall Street Journal in 2009 on the origins of the credit bubble. He concluded by saying, "In the end there can be no substitute for good judgement."

Small business lending is, without question, just as much art as it is science. Your chances of seeing your loan approved are far better when you understand that art and can position your company as credit worthy. It's your job as the small business owner to make that judgement as easy as possible.

Take advantage of this little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report, "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.


Read/Post Comments (2) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 04, 2014, at 4:38 AM, eddiecaz wrote:

    Great article! I just had to go through this experience as i was looking to expand my business, and this exactly what the lender was looking at.

    Fortunately, i was able to get the loan i wanted. The rates are not like the bank's but i guess that's how it is! i got my loan from funderz.net and I recommend them because they got me the money pretty fast!

    Again, that was a good read!

  • Report this Comment On October 16, 2014, at 3:19 PM, calebhart54 wrote:

    I'm looking to apply for a loan to start up a business. I have never applied for a loan in my entire life and I am really nervous about going in. This article explains what I can expect in the process and how to make sure that I get my loan approved. I didn't know what collateral meant before I read this article, so that was one more thing that I was taught. http://www.kosterfinance.com

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 3087277, ~/Articles/ArticleHandler.aspx, 10/20/2014 1:15:19 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement