3 Tests To Qualify For A Small Business Loan

Banks and other lenders are really only concerned about one thing; getting repaid.

After all, that is how they still make the bulk of their revenue; making loans and getting repaid both interest and principal.

Thus, to qualify for a business loan, you simply have to demonstrate that your business can service the loan request – meaning being able to make the loan payments for the life of the loan.

Most lenders will perform the following 3 analysis calculations to determine if your business has the cash flow to service the proposed new loan.

1) Spread The Financials:

Banks / lenders will require three years of past financial statements at a minimum. The reason is to see if your business could have serviced the loan over the last three years. If it passes this test, then your business should be able to service the loan for the next three years.

Thus, they use your past business performance to determine what your future performance should be.

To spread your financial, most lenders will do the following for each past period that your business provided financial statements:

  • Take your net income (that is your net profits after all operating costs, taxes and interest payments).
  • Add back any non-cash accounting items like depreciation (deprecation is not an ongoing cash expenses but an accounting anomaly to reduce taxable income for tax reporting purposes only).
  • Add back any one-time charges or expenses – expenses that are not expected to reoccur in the future.
  • Then subtract out the interest charges for the proposed loan – only the interest portion at this stage as interest payments are considered regular business expenses.

This results in the true net positive (hopefully positive) cash flow of the business – cash flow that will be used to pay the principal portion of the business loan.

Now, if your business’s cash flow at this point can cover the principal portion of the loan, you have almost pasted this test.

Most lenders will not just want to see if your business’s cash flow meets the minimum principal portion of the proposed loan but would like it to cover 25% or even 50% more. The reason is that should your business have a slow period and revenues decline by say 25% or 50% – your business’s cash flow would still be sufficient to make the loan payment.

Example: Your business requests a $100,000 loan for three years with a monthly payment of $3,227 – broken down as interest of $449 and principal of $2,778.

Therefore, your monthly cash flow should not only cover the $2,778 in principal but say 1.25 times more or $3,473.

Also, keep in mind that this cash flow figure should not only cover the proposed loan’s principal but the principal payments of all the business loans the company has.

Principal payments are not income statement items and are not accounted for based on normal operating income and expenses but are balance sheet items and are paid out of net income (after all operating expenses).

Interest charges from loans are an operating expense and accounted for when the financials are spread.

Financials could be spread monthly, quarterly or even annually – depending on the types of financial statements requested or the policies of the lending institution.

If you can past this test via your past business performance, then it is highly expected that your business will do the same in the near future.

2) What If Scenarios:

Here, the lender will perform a series of “what if” scenarios on your financial statements.

For example, they may take your total revenue per period and reduce it by 10% or 20% – keeping all other items (your expenses) the same.

Then, spread those numbers again to see if your business could still service the proposed loan – e.g. still have the cash flow to make the payments.

Again, reassuring the bank or lender that your business would still be able to repay them should your business hit a slow period.

3) Debt-to-Equity Ratio:

Lastly, while your business may be able to service the proposed loan’s payments, banks also want to ensure that your business is not over leveraged – meaning that your business does not have too much debt in comparison to its equity.

Let’s say that the entire market declines or crashes and your revenues fall so low that you are forced to shut down the business. In this situation, would you still be able to repay all your lenders – including this proposed loan?

Thus, lenders look to a safety measure known as the debt-to-equity ratio.

Measuring your debt-to-equity is simply taking your Total Liabilities and dividing them by your company’s total equity.

The higher this ratio, the more risk the business has as it is relying on too much outside debt financing.

A ratio over 3 (meaning that the business has three times the debt as it does equity) is too much risk for most lenders to feel comfortable with.

Most businesses will have a debt-to-equity ratio between 1.5 to 2 and are considered safe to their prospective lender.

Now, if your business does not pass all these tests with flying colors and you still need a small business loan to grow, then it is up to you (the business owner) to manage your company in such a way to bring your business in line with these tests.

It all starts with your understanding of your business and the measures it has to pass to qualify.

Guarantors For Business Loans

A guarantee is basically a promise to satisfy the performance of an agreement. A guaranty is similar, but is used to satisfy the performance of a loan by an individual. Analysis of credit and guaranties is a discipline that only the most qualified people should perform. Investigating guaranties is never performed alone -it is part of the overall credit review of a business requesting a loan. It is a complex set of procedures beyond the scope of this article. This article will summarize the elements involved to investigate a business loan guaranty. Consult with your CPA or Banker for assistance before attempting to do it yourself.

Investigating a personal guaranty for business loans is part of commercial credit analysis. The credit-underwriting department of a commercial bank or business lending institution typically performs this analysis. Any institution or person considering the extension of credit related to a business can perform credit examination. All guarantors must complete a Personal Financial Statement accompanied by tax returns and sometimes-additional supporting financial statements. Guaranties are legal agreements that obligate a third party, usually a business owner or key corporate officer, to repay a business debt should the business entity default on its repayment of a credit facility. A guaranty is not a primary source or substitute of a borrower’s credit worthiness.

Personal guarantees are frequently obtained from the owners of a corporation, partnership or any other form of a business entity. From the lender’s perspective, a personal guaranty ensures the personal and business interests of the owners are equivalent. If the business entity defaults on the loan, the guarantor promises to cure the default. Since most guaranties are unsecured, their values are more psychological than tangible. However, a lender can ask for some type of personal collateral of the owner for additional security for the making the loan. For example, the lender may ask for a pledge of a secondary lien on the owner’s home. The type of property pledged depends on the risk factors calculated by the lender. Some property holds greater security values than others.

Investigating the credit worthiness of a loan and a guarantor involves careful credit investigation. In commercial lending, banks will apply principles called the 5 Cs as a basis for credit examination. The 5 Cs are Character, Capacity, Capital, Conditions, and Collateral.

Character – This relates to the motivation of the borrower to repay a debt obligation. It is unlike any other financial performance indicator found in the financial statements. Determining character is a judgment call derived from careful interviewing of the applicant and study of the applicants’ historical credit reputation. Background checks and interviews with others having business relations with the applicant are useful to make a fair appraisal.

Capacity – “Cash is King”. Loans are repaid from cash generated by the business’ operating cycle. Can the borrower manage their cash efficiently enough not only to repay the loan, but all other debts simultaneously? Historical financial performance is evaluated to determine how the borrower handles their debts and expenses. Sources to review include the Income Statement, Statement of Cash Flows, and partially the Balance Sheet. A new or very young business is difficult to judge because they have not yet accumulated enough historical data to review.

Capital – It is the funds available to operate a business. The two primary conditions in this area involve the amount of owner’s equity (OE) and efficient uses of the capital to operate the business. It is not good when borrowed capital (credit) is greater than OE. Careful scrutiny of the Balance Sheet is required in this area. The purpose of capital is to maintain operations. Borrowing funds to augment operations is normal. However, too much borrowed capital is a sign that something is wrong.

Conditions – These are external factors relative to the industry of the business. The current state of the economy is a good example. Industry events and situations (current and predicted) are taken into consideration as to how it affects the business. For example, if a key supplier of the business experiences a labor strike, further investigation is needed to consider the affect on the business. Interviews with key officers and the business owner can shed light on what is happening. Additional resources like trade journals, industry news reports and the like are useful tools.

Collateral – Lenders want repayment from cash, not property. The last thing a lender wants to do in a default is take the property pledged backing up a loan. Property pledged is only a means to offset weaknesses in the other Cs. It is a safety net of last resort should a loan default a secondary source of repayment. A collateral pledge is completely irrelevant if the loan request contains too many negative signs in the foregoing credit assessment areas.

Guaranties are generally classified as unlimited and limited. An unlimited guaranty covers all the debt obtained by a single borrower to a single lender. Limited guaranties are associated linked to a specific loan with a capped dollar amount.

Other types of guaranties include corporate and government agencies.

Corporate guaranties are similar to personal types except it is generally one corporation guarantying the debt of another corporation. Usually, large corporations guaranty the debts of its smaller subsidiaries or new business units.

Government guaranties are special situations, whereby a state or federal agency guarantees a business loan. An example agency is the Small Business Administration (SBA). Governmental guaranteed loans are very complex and typically take longer to process. A lender processing governmental secured loans must adhere strictly to the guidelines of the agency guaranteeing the credit. Under an SBA loan, the lender provides the money to the borrower and the SBA guarantees the loan amount up to certain percentages depending on the program loan used. Each loan program has specific qualifications and conditions attached to it. Anyone can contact the SBA directly for more information by visiting www.sba.gov. It is recommended to speak with an SBA approved lender to see what options are available. Obtaining an SBA loan is often the best choice for a business because the borrower cannot qualify under conventional terms. The SBA assumes most of the risk, thus making the credit request more palatable for the bank.

Careful credit examination is required to investigate any guaranty for business loans. Analysis should account for all tangible and intangible factors of the individual guarantor with the associated business. The guaranty does not stand alone without review of the business. Credit analysis is both an art and a science. Sound judgment based on financial data, combined with practical experience is necessary to consider all variables of a credit request. Professionals that have formal credit training usually perform business loan analyses. Consult with your CPA or Banker for assistance before attempting to do it yourself.

Small Business Accounting Explained

Below we give you some tips on how to make small business accounting more bearable for you.

First, you should make a list of all accounting tasks to perform in your business. Once you have your list, small business accounting is less stressful and takes less time. You will only have to perform one or more tasks at regular intervals (daily, weekly, monthly …).

We also recommend that if do not know a lot about small business accounting, learn the basics.

Small business accounting is a specific jargon and all sorts of words and concepts reserved for the experts. Do not be discouraged if you do not understand them all. Get used to the most basic concepts directly related to successfully improving your small business accounting. Ultimately, the goal is that you increase profit. It is the primary goal of any business. Request help from a professional if you want, but do not miss the basic concepts.

In contrast, it is a mistake to become a super fan of small business accounting. The company does not come down to accounting. There are firms and professionals who do this very well. This is not the job of an entrepreneur to be a know-it-all of Management or Accounting.

The third golden advice is to separate your personal finances from your business finances.

It is a bad idea to mix your personal account and your business account. Separate them completely: even if you’re the sole shareholder in the company, even if only your money is put into the pot. This separation enables you to plan, predict, without confusing personal cash and professional cash. This allows a lucid view of the true accounts of the company.

Finally, you must be consistent.

It may be hard to get used to at first but we recommend that once you create an accounting system for you, you should stick to it no matter what. Remember to register everything, forget nothing, and be consistent. If you are not consistent you will start doubting your own system later which will not help you when you want to evaluate your business performance at the end of the year. It is a good idea to meet with your accountant to have him or her verify the information.