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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.
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.
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.
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?
The quick ratio (or acid test) shows what assets your business can immediately convert to cash, such as the business checking account and money market accounts.
The current ratio is a broader indication of liquidity because it includes inventory. For purposes of showing your immediate access to cash, many lenders find it less useful than the quick ratio. In general, lenders look for your current assets to exceed your current liabilities.
Leverage.
The leverage ratios measure the company’s use of borrowed funds in relation to the amount of funds provided by the shareholders or owners. These ratios tell the lender how much money you have borrowed versus what money you and other owners have put into your company. This is important because borrowed money carries interest costs and your business must generate sufficient cash flow to cover the interest and principal amounts due to the lender. Generally speaking, companies with higher debt levels will have higher interest costs to cover each month, so low to moderate leverage is nearly always viewed more favorably by prospective lenders.
The most common leverage ratio is called, simply, the debt ratio: total liabilities divided by total liabilities plus capital.
Turnover.
The turnover ratios focus on the operating cycle of your business by examining its cash flow. They show the amount of time it takes for cash to move through the accounts receivable, inventory account, and accounts payable in your business.
It is important to know how many days it takes your company to purchase inventory, pay for it, sell it, and collect the cash for the sales. Credit sales may not actually produce cash for 30 to 60 days. If you don’t understand this cycle you can find that you have to pay for new supplies before your customers have paid you.
Gaining an understanding of the cash flow of your business is the most important financial planning tool you have. An examination of the turnover ratios can help you to understand the operating cycle in your business.
The three turnover ratios are the collection period ratio, the days to sell inventory ratio, and the days purchases in accounts payable ratio.
The collection period ratio indicates how quickly you collect the cash your customers owe you. The earlier you collect it, the sooner you can put it to work; so the lower the number, the better.
Days to Sell Inventory Ratio
Along the same lines is the second turnover ratio, the days to sell inventory ratio. The days to sell inventory ratio tells how efficient you are at matching your purchases to your sales. Low inventory days indicate that you’ve accurately forecasted the demand for your product. That way excess inventory isn’t accumulating on your shelves and adding to costs.
Days Purchases in Accounts Payable Ratio
The days purchases in accounts payable ratio is the third turnover ratio. This ratio measures how quickly you pay your suppliers for inventory purchased. Generally speaking, it is advantageous for small businesses to pay for products promptly so they can take advantage of price discounts.
Pro Forma Financial Statements and Financial Projections.
Pro forma financial statements are the entrepreneur’s best guess about what next year will look like for the business. These tools will help you anticipate whether next year’s cash flow will be sufficient to cover all your costs, and if not, how much money you will need to borrow.
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