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How to Qualify for a LoanBefore you approach your banker for a small business 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 that loan. This article will discuss some of the key factors that any bank uses to analyze a potential borrower. Included you will also find a self-assessment checklist that you can complete before preparing a loan request.
Key Points to Consider
1. Ability to Repay/Capacity
The ability to repay must be clearly explained in your loan package. Banks want to see two sources of repayment - cash flow from the business, plus a secondary source, such as collateral. Generally banks feel most comfortable dealing with a business that has been around for a few years and has a financial track record. Past financial statements will be reviewed. If a 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 the business is a start-up or has been operating marginally and now has an opportunity to grow, then it becomes necessary to prepare a thorough loan package with financial projections and detailed explanations addressing how the business will be able to repay the loan.2. Credit History
The first thing a bank will consider is whether personal and business credit is good. Before approaching a bank or preparing a loan package, you want to make sure your credit is good.To obtain a copy of your personal credit report, call TransUnion, Equifax, TRW or another credit bureau. The internet also has many sources for obtaining your credit report. Plan this well in advance of seeking your loan. Personal credit reports may contain errors or be out of date; many times people find that they have paid a debt but that it has not been recorded on the report. It can take up to three or four weeks for the error to be corrected, and it is up to you to see that the correction takes place. You want to make sure that when the bank pulls a copy of your credit report that your credit history is up to date and correct.
Many people receive a copy of their credit report and are confused by what the strange numbers signify. The following should assist in interpreting you personal credit report:
First, check your name, social security number and address at the top of the page to make sure they are correct. Some people have found credit information from another person because of mistakes in their identification information.
You will see on your credit report all of the credit you have obtained in the past - credit cards, mortgages, student loans, etc. Each will be listed individually with information on how you paid. Any credit where you have had a problem in paying will be listed toward the top of the list. These are the credits that may affect your ability to obtain a loan.
If you have been late by a month or more on an occasional payment, this probably will not adversely affect your credit. If you are continuously late in paying your credit, have a credit that was never paid and charged off, have a judgment against you, or have declared bankruptcy in the last seven years; it is likely that you will have difficulty in obtaining a loan.
Sometimes a person has a period of bad credit based on a divorce, medical crisis or some other significant event. If you can show that your credit was good before and after this event and that you have made an effort to pay back those debts, credit blemishes can often be overlooked. Write an explanation of your credit problems and explain how you have rectified them. Attach the explanation to your credit report in the loan package.
Each credit bureau has a slightly different way of presenting your credit information. You can get specific information on how to read the report from the individual company.3. Collateral
Financial institutions are looking for a second source of repayment, or collateral. These are personal and business assets that can be sold to pay back the loan. Every loan program, even many micro-loan programs, require at least some collateral to secure a loan. If a potential borrower has no collateral to secure a loan, he/she 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.See the table below for a general approximation on how different forms of collateral are valued by a typical bank and the U.S. Small Business Administration (SBA).
Market value x .75 mortgage balance
4. Equity
Banks will want to see a certain amount of equity in a business. Equity can be built up 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. You must ensure that there is enough equity in the company to leverage that loan.
Don't be fooled into thinking that start-up businesses can obtain 100% financing through conventional or special loan programs. In most cases, a business owner must put some of his/her own money into the business; that amount is dependent on the type of loan, purpose and terms. Most banks ask the owner to put in 20% to 40% of the total request.
Example: A new business needs $100,000 to start. The business owner must put $20,000 of his/her own money in as equity. The loan amount would be $80,000. The debt to equity ratio is 4:1. This is only one of many factors used to evaluate the business. Just having the right debt to equity ratio does not guarantee you will get the loan.
The balance sheet indicates the amount of equity or net worth of a business. The net worth of the business is often a combination of retained earnings and owner's equity.
For more information on under-standing your balance sheet, ask to speak with an SBDC consultant.
5. Experience
If you want to open a business and have no experience in that business, you should not seek financing, let alone start the business, unless you intend to hire people who know the business or you take on a partner with the appropriate experience in the industry. Regardless, you will be advised to take some time to work in the business first and to take some entrepreneurial training classes. Management experience is a key factor for lender confidence in your application.Questions Your Banker Will Ask
- Can the business repay the loan? (Is cash flow greater than debt service)?
- Can you repay the loan if the business fails? (Is collateral sufficient to repay the loan?)
- Does the business collect its bills?
- Does the business control its inventory?
- Does the business pay its bills?
- Are the officers committed to the business?
- Does the business have a profitable operating history?
- Does the business match its source and uses of funds?
- Are sales growing?
- Does the business control expenses?
- Are profits increasing as a percentage of sales?
- Is there any discretionary cash flow?
- What is the future of the Industry?
- Who is your competition and what are their strengths and weaknesses?
Commercial Loan Evaluation Factors
The following factors indicate the "ideal" situation for approaching a bank for a small business loan. If you cannot respond yes to all of these factors, you could still obtain finan-cing. If you are weak with respect to one factor, but strong in another, your overall situation may allow you to obtain a loan.
Applicant Factors
- Credit: excellent ratings and no personal or business bankruptcy.
- Arrest: no arrest for fraud, theft, embezzlement or drug/alcohol abuse.
- Cash: applicant has 20% or more of cash needed for the project.
- Net Worth: applicant has net worth (for use as collateral) greater than 100% of the loan amount.
- Income: applicant does not need to draw income from the project for a period of time. Fixed payments per month (house, car, credit cards) do not exceed 40% of net income. (A working spouse who can cover living expenses is highly desirable. You must provide three years of tax returns to verify your income and standard of living.)
- Experience: applicant has three to five years general management experience as a minimum and, preferably one or more years of industry specific experience.
Remember, if you are weak with respect to one factor but strong in another, your overall situation may allow you to obtain financing.
Business/Financial Factors
- Buying an existing business
a. Profitability: must have good track record verified by three years of financials & tax returns.
b. Gross Sales: should be in excess of $100,000 per year.
c. Asking Price: should have a thorough valuation including appraisals.
d. Market Position: should have a good market position.
e. Financial Ratios: should compare favorably to industry standards.- Starting a New Business
a. Market: must have a thorough market analysis.
b. Location: must be a clearly good location.
c. Experience: applicant must have excellent experience.- Expanding a Business
a. Profitability: good track record
b. Cash Injection: must have at least 10% of cash needed.
c. Financial Ratios: better than industry standards.- Any Business
a. Liquidity Ratio: 1:0 or better
b. Coverage Ratio: 1:2 or better
c. Debt/Equity Ratio: 3 or higher
d. Detailed Business Plan: including three years pro forma statements.Self-Assessment Checklist
Whether you are applying for a microloan, SBA loan or a traditional bank loan, there are certain factors that improve your ability to obtain financing. The following is a simple checklist to complete before you begin to seek capital.
- Do you have a good personal credit history?
- Have you filed all income tax returns?
- Are your income taxes paid?
- Does the business have the ability to repay a loan?
- Does your business have a positive net worth?
- Is your business already carrying too much debt?
- Do you have enough of your own money in the business?
- Do you have collateral to secure a business loan?
- Are you willing to personally guarantee a loan?
- Does your business have qualified managers and advisors?
- Do you have experience in running your own business?
If you cannot answer yes to all of the questions above, then you may have difficulty obtaining financing at this time. The Small Business Development Center is here to provide you with free of charge and confidential counseling to help you increase the chances of obtaining financing.
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