If you own a business and you’re looking to finance an equipment purchase, real estate, a vehicle, line of credit, letter of credit, or whatever your lending needs may be, there are many variables that will be assessed by the bank when you go to apply.
First and foremost, the bank will require you, and whoever else is going to guarantee the request with you, to sign something that permits them to pull personal credit reports for all guarantors on the request, which typically will be all owners with a significant ownership in the business. It depends on the institutions lending policy, but there are certain circumstances where guarantees may not be required for an array of mitigating factors.
A not for profit business is ran by a board of directors and is not owned by individuals, so there are no owners to guarantee the request. An individual can decide to add their personal guarantee to a not for profit loan request to strengthen the loan in the eyes of the bank, but this doesn’t happen often.
With your permission the bank will pull personal credit reports for all guarantors and sometimes a business credit report as well, depending on the institutions policy and the level of exposure (total of all loan balances/availability). The bank will be looking at the overall credit score, your credit history, length of established credit lines (which is why you should never close out your oldest credit card), size of total debt, credit utilization (meaning of the revolving credit limits, what percentage are you currently utilizing; less utilizstion is more when it comes to a getting a higher score), collections accounts, tax liens, both federal and state, bankruptcy history within the past 7 years, foreclosures, repossessions, past due accounts, frequency of late payments, recent late payment, outstanding judgments, etc.
If you’re aware of any outstanding issues above, be sure to clear them up before submitting your loan application. There are plenty of free credit report websites around these days (CreditKarma) so pull your report before applying and be ready to address, explain, and provide documentation supporting your side of anything the bank may perceive as a negative sign in your ability to repay the debt.
Ideally your credit score should be at least 640. Anything in the 500’s or below you better be ready to provide some strong mitigating factors to compensate for the poor personal credit history. And if your score is low and you want to establish credit you can cash secure a line of credit or term loan, meaning you secure the request against an account fully funded with the amount you will be borrowing with your own cash, which you cannot touch as long as it’s being used for collateral, and the bank will lend to you risk free on their end. The whole point in this is to establish a positive credit history and lending relationship with the bank.
If you have an existing relationship with the bank they may also look at your current, or average deposit relationship, if you have a history of overdrawing accounts, and late payments on any existing loans.
If you are looking to purchase equipment, or a vehicle the value, and age of the equipment which will be secured as collateral matter. If a piece of equipment is too old, the bank may consider the value of the item fully depreciated and worthless as collateral. If that’s the case they will not approve the loan because it would be considered unsecured.
Banks will often search for comparable items and what they’re selling for, but again, if the equipment is too old and you’re looking to finance it over the term of 5 years, the bank will have to take into consideration what the asset is worth over the coarse of that 5 years. If you’re cutting it close, they will sometimes propose a shorter term on the loan which means you pay it off faster, but the payments are larger and a drain on your cash flow, which will require even more strength.
Additionally, if you’re looking to finance a roof, furnace, or anything attached to the structure of a building that may be considered part of the structure, the bank will not finance the project if they don’t already have a mortgage on the property, and if the proposed loan does not include securing the entire property. If you fail to pay the loan they can’t take a roof back so again, you run into a collateral issue. If a bank is willing to offer unsecured financing that may be an option, but the rate will typically be higher due to the increased risk.
A mortgage will require an appraisal and typically you will be able to lend up to 80% loan to value. In other words, if the property is appraised at $100,000, the maximum amount you can borrower is $80,000. You will be responsible for coming up with the remaining $20,000 cash. If the sales price is more than the appraised value, the loan to value is still based upon the appraised value and you will then be required to put down an even larger percentage of the sales price.
Next, the bank will typically have you provide a personal financial statement listing all your personal assets, and liabilities in order to calculate your net worth. Assets consist of real estate, your home, vehicles, life insurance, cash, marketable securities, 401k and retirement accounts, jewelery, etc. Liabilities are loans payable to the bank, any notes you owe, debt, and obligations from your credit report. They look at the personal financial statement for items that may not be on the credit report such as child support, alimony, or non bank debts you may owe to another person.
A large determining factor with most banks is something called the debt service coverage ratio. This is a ratio of net operating income, or total net income earnings plus adding back interest, depreciation, amortization, and any one time expenses or sources of income, divided by total annual debt service. Basically you’re taking the net operating income, adding back non cash expenses like depreciation, adding back interest since it will be accounted for in the debt service (principal and interest), and any one time items that cannot be expected to reoccur, and dividing it by all your monthly debt payments times twelve to come up with the annual obligation.
What the result gives us is a ratio which represents how much cash you have relative to your debt obligations. 1.0 equates to just enough cash to cover all debt. A bank will typically like to see a ratio of at least 1.20 meaning you have an excess cash flow of 20% of your total monthly obligations after all expenses are covered. The higher the number the better. If you’re below 1.20 you will most likely be asked to reduce the request, or be declined.
You can take your financial statements or tax returns and do the calculation yourself to have an idea before applying. The bank is going to add the requested amount to the debt service portion so they’re not looking at where you currently are, but where you will be with the new monthly obligation of the loan you’re requesting added on. Be sure to do the same when you look at this for yourself.
To figure out what your new payment would be on a requested loan you can use the payment function in Microsoft Excel, or visit the following website: Amortization Calculator. Pay attention to the total of all payments to see what you’ll really be spending over the life of the loan with interest. The bank takes a very significant interest amount over time. Note that this calculation is for principal and interest payments (P&I). If your payments are going to be structured as interest only, or principal plus interest (P+I) the payments and debt service total will be different.
Also make sure that you’re adding back all types of depreciation and amortization. Especially if you’re looking at a federal tax return because there are different types of depreciation that can be accounted for on different sections of the tax return. And if you’re refinancing old debt with new debt, subtract the old from the debt service portion because you don’t want to double count it when the old is going away, and included with the new payment.
If you’re looking to purchase a non owner occupied piece of real estate then the rent roll will be an important document to base the decision off of. The bank will look at historical rental income, vacancy risk, historical expenses, and calculate the debt service coverage ratio based upon the rent roll and expenses, or schedule E from a historical tax return for the property. For a newly constructed building with no historical rent roll, the appraisal will usually provided an estimated monthly rental income, or an estimate can be determined by a market comparison.
Another factor that can impact the cash flow are distributions. If you’re taking money out of the business you’re depleting the businesses retained earnings. The money is still moving to you on the personal side and that may be taken into consideration for a global cash flow (debt service ratio based upon the business as described above, plus personal sources of income, and personal debt), however keeping it in the business comes across as a stronger move in terms of strength of the borrowing entity.
The bank will also assess your balance sheet. Specifically they will look at your current ratio, which is current assets, divided by current liabilities. The higher the number the better. This ratio shows how much current, more liquid assets you have, relative to short term liabilities (liabilities owed within one year). Significantly more current assets than current liabilities is a sign of strength. The opposite shows weakness on the balance sheet.
Lastly for the balance sheet, the bank will typically look at the leverage ratio, which is total liabilities divided by tangible net worth. Total liabilities is the total of both current and long term liabilities, tangible net worth is net worth, less any intangibles on the balance sheet such as goodwill. This ratio is comparing all your liabilities to the tangible worth of your business. The smaller the resulting number the better. This means that relative to the tangible net worth of your business, your total liabilities are a minor concern. If your total liabilities are significantly more than your net worth, this can be a cause of concern.
Bank policies may require a minimum time in business in order to obtain a loan. Typically they will base this upon the date of your businesses filing with the state you organized with through that particular states secretary of state (SEC) website. If your business changed names, or has existed longer term reported on a schedule C as a sole proprietor, be ready to provide an old schedule C to verify longer time in business. If you still are a sole proprietor you’ll want to provide an older Schedule C from your tax returns regardless.
If the bank is issuing a line of credit secured by a first position blanket lien on all business assets then you’ll want to be sure that you do not have any existing loans with different banks who may have already taken a first position lien on all business assets. If they have already, you’ll need to refinance that debt with your new bank, or pay the loan off yourself to terminate the existing lien. Alternatively you can request that your existing bank subordinate their debt to your new bank, giving your new bank the first position lien they demand. You can go to your states Department of State Division of Corporations, State Records & UCC website to search your business for outstanding liens.
What was just discussed covers existing businesses with historical financial information. If you are a new business you are automatically considered high risk because so many businesses fail the first year, or first few years. If you want to apply for a loan you’ll have to provide a detailed business plan including projected financial statements (typically at least 5 years), information on the business, the industry, the competition, the owners, their background, competitive advantages, etc. There are colleges and services out there who can help put this together for you.
If you’re a riskier industry, or a new business, ask your banking officer if you may qualify for a Small Business Administration (SBA) loan. This is a special type of facility where a significant portion of the loan is guaranteed by the federal government to encourage banks to lend to businesses that wouldn’t qualify for traditional financing.
This takes a nice portion of the risk off of the bank and gives these businesses access to financing. Additional documentation may be required and this option isn’t available if you’ve been convicted of a felony. Other than that, if you’re a new business, or operating in a risky industry, this may be something worth asking about.
It can be worth while to negotiate your interest rate or administrative fees, especially if you have large deposits with the bank, a strong credit history, and strong financial ratios discussed above. There’s usually someone with the authority to bend things in your favor if the bank doesn’t want to lose your business. You can also rate shop multiple banks to see who can give you the best rate, with the least amount of fees, in the quickest amount of time. Having multiple offers on the table can provide leverage when you go to negotiate. If you ask for a better rate, the worst they can say is no.
Every loan application is a unique situation and there are so many variables that go into the final decision. My hope here was to give you a solid overview of what the bank is looking at and what they’re concerned with so you can present your business in the most favorable way, to obtain the financing you need, and to get the best deal for your business.
I hope you found this information helpful. If you have time, check out my post on how to start saving money now SoLongMediocrity.by