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.
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.
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.
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.
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.