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Is Your Business Established?
One of the factors a bank will consider before lending money to a business is how established that business is. Did you just start your business last month, or have you been operating for the last four years? A business that has successfully been operating for several years will have a better chance of securing funding than a newly born business, most businesses fail within their first year of operation, and are considered high risk by lenders.
A key issue for businesses trying to obtain financing is related to your timing. If you wait until you are in a cash flow crunch, you lose your negotiating power with the potential lender, and your overall financial position is weaker than if you look for capital before the cash flow situation arises.
How leveraged are you?
Banks will look over your income statement and balance sheet to come up with financial ratios. They'll run numbers and generate predictions to see whether or not you have the ability to make loan payments, and how likely you are to continue having the ability to make loan payments in the future.
One of the common tools to asses a business is their debt-to-equity ratio which is simply the total amount of your business debts divided by the equity in the business. The equity is determined by subtracting all of your debts from your assets. A quick example:
Assets
Cash $10,000
Inventory 50,000
Liabilities
Accounts Payable $40,000
Equity would be $20,000 ($60,000 in assets less the $40,000 in debts) and the debt-to-equity ratio would be 2:1 ($40,000 in debts divided by $20,000 in equity).
Generally speaking, the higher the debt-to-equity ratio, the more risky a business is, but there are many other factors a bank will consider. One of those is the industry you are in. Some businesses are by nature more leveraged than others. It is a good idea to know where your company stands compared to its peers before you request a loan from the bank.
Are You Securing the Loan With Collateral?
When a business wants to take out a loan or line of credit, often they'll be asked if they have any collateral that the bank can use to borrow against. This reduces your risk in the eyes of the lenders, since if you fail to keep up with your loan payments the bank has the right to take whatever you used as collateral to recover their money. Proof of value for items used as collateral will need to be established, and you may find the bank has a different idea of what the potential collateral is worth than you do!
Collateral for loans determines the terms of the deal. Generally, loans with collateral are viewed as less risky, and therefore have lower interest rates, and have longer repayment terms. Also, the more long term the collateral, the longer the term of the note, for instance, a real estate loan will have a longer repayment than one secured by accounts receivable.
Some commonly used collateral include:
* real property
* equipment
* accounts receivable
* inventory
* intellectual property
Personal Guarantee for Small Businesses
Many small businesses will be asked to sign a personal guarantee on a business loan. Your signature indicates that you will be personal responsible for assuming the debts of the business if the business defaults on the loan and is unable to pay back the money. It reduces the risks to the bank lending the money to a business, because they have another avenue (you) to pursue if the original borrower (the business) does not keep up with payments. Sometimes the business owner will be asked to assign a portion of their personal assets or property over to the bank in order to secure the business loan.
Cash Flow and Profitability
A well established business can sometimes obtain financing if they show a good history of cash flow and profitability. Banks will determine this information through your financial statements, including your income statement and balance sheet and will probably want to view at least three years of records. It is important to consider the impact of the new loan. Often times, the bank will 'pro forma' the financial information you give them to see if the new loan can be serviced by the existing profits of a company. Many times a business owner will want to consider the profits that will be made with the loan (additional inventory or new equipment), but a bank takes a more conservative approach to see if the historical profits will support the new debt.
