Understanding the Bankers' Formula
By Linda Plater | August 31, 2001
Has your small business ever been turned down for a bank loan? If so, you're not alone.
Did you ever find out why you weren't approved for a simple line of credit or capital loan? The truth is, many small businesses once rejected by the banks never know exactly why they've failed to secure the financing they need to grow their enterprises. Success or failure can depend heavily on your ability to inject cash into the business from non-lending sources such as personal savings or private investors.
This is the first of a series of articles that will look at bank financing for small business. The series will outline the factors that a banker considers when evaluating loans. It will also reveal some balance sheet "must-haves" to help your business get in shape for lender scrutiny. Finally we'll examine some common mistakes small businesses make when applying for loans. You'll also get some tips on how to avoid making errors or oversights that can lead to a rejected loan application.
Even before entrepreneurs apply for a loan, they need to understand how early decisions made during the year or even several years before applying for a loan can impact on their ability to get debt financing.
The Loan Application
Most business owners think loan applications are all alike. Not true! Applications vary depending on the reason you need to borrow, and the type of loan. For example, cash flow lenders look at different criteria than asset lenders, and lines of credit have different requirements than term loans.
However, these days automated application processes can churn out your approval or rejection in a matter of seconds. In the past the loan review process took much longer. Still some lenders do take the time to visit a business site to better understand its inner workings and to determine loan eligibility.
To prepare for the application process, go online or drop into your branch. Look over some applications so that you understand well in advance exactly what the bank is looking for from your business. It may take you several successful quarters before you even meet the criteria outlined in the application. So, set yourself up for success before you even apply!
Smart tip: Do your homework. Review several loan applications and understand the business of the bank where you plan to seek funding.
Although some banks are moving away from scrutinising personal finances, it is still very common for them to rely on the information business owners have in their personal credit files. That's why paying all your bills and paying them on time – even if it is just the minimum payment – is important when it comes to keeping your credit record healthy. The way you deal with paying suppliers and other businesses can show on your credit report so it's crucial to keep on top of your payables.
For most banks, maintaining a good credit record is the single most important factor in their loan decision-making. When it comes to scoring well on your credit score, the higher the number the better. Banks will verify that the business has the ability to pay down its debt. And they don't like to see individual owners of a business or a company over extending themselves.
It's quite common for start-ups to rely on flexible lines of credit and personal credit cards to finance the early stages of a business. For new graduates, some banks offer introductory credit card programs that are checked through personal credit bureaus. Just because you get credit doesn't mean you'll always keep it. Remember to pay at least the minimum on your monthly statements.
Smart tip: Keep your financial house in order at all times and show that you pay your bills.
The Numbers Please
It's no secret. Bankers like numbers, preferably positive ones. But beyond the figures on your business balance sheet, it is important for anyone applying for a loan to understand what the numbers they present to the bank really mean. Maybe your sales have increased, but you report several slow quarters. You've got to be able to explain this to your banker to stand a chance of getting the loan you may so desperately need to grow your business. Any new loan, extension or line of credit application will need to be backed by solid numbers that prove a financial need and most importantly your ability to service the loan.
Bankers will also look at how long you can afford to run the business without their help. This means you need to show accounting that makes sense. Your cash flow, including net income and amortization, need to appear on the balance sheet. They'll also consider investments in the business including: retained earnings, accumulation of profit generated, shareholder equity, and payables outstanding over the equity and loan inputs.
While security or collateral is also factored into the lending equation, a company's earning potential may prove more important. According to Cathy Ierullo, BDC Area Branch Manager in Mississauga, "Earnings and potential earnings in the business are more important than the security in the business."
Smart tip: Understand what your numbers represent and be able to explain them to the bank.
What's a Ratio?
The most common way loans are evaluated involves mathematical calculations called financial ratios. Although they vary for different industries, lending institutions look your ratios to determine loan eligibility. From the ratio, they can tell if an applicant faces cash flow problems.
An acceptable debt to equity ratio for a lender to consider your loan is usually about 2:1; more than 2:1, is getting into a risky territory where most lenders don't like to venture. The more debt cuts into the business, the more difficult it is for a company to service the debt. Banks want to see in your cash flow an ability to pay off debt.
Beyond the debt to equity ratio lenders can look at your current ratio, which compares current assets to current liabilities. In other words, how your accounts receivable offset your accounts payable. They look at your working capital and inventory funding compared to current liabilities.
How you manage your receivables can also impact your current ratio. Well-structured business processes can ensure that you present an acceptable current ratio to the bank.
Smart tip: Know how to package your financial statements to reflect a debt to equity ratio and current ratio acceptable to your lender. If your ratios look out of sync with your industry, be able to explain why.
Financing, not Accounting
You might not know it or your accountant might not have explained this to you, but sometimes paying less tax can negatively affect your ability to secure financing. This move, called optimization, can harm your chances of securing a loan if your profits are not reflected on your corporate balance sheet.
What a tax expert can do is prepare a business statement and reconcile it with your tax strategy to show the actual net income before tax planning. Creating this type of statement prior to optimization can look more attractive to potential lenders.
For companies in growth mode, reducing taxes should not be their first priority. It is important though to avoid letting your tax bills cut into your profitability and your ability to grow the business. Your financial advisor needs to understand the future expansion plans for your business. An accountant should be your strategic partner in forecasting financial planning decisions. Therefore, make sure you share all of your financial plans with your accountant because solid financial advice is key to your business growth.
Ask your advisor, "What do I need to show in my cash flow, revenue wise and income wise, to demonstrate that the business is making money?" Bankers want to see equity and profits.
Smart tip: Get expert financial advice to plan for financing business growth first and tax reduction second.
First and foremost when considering your credit application, the banker wants you to demonstrate your business viability. This factor is all about management expertise and profitability.
What is the background of the people related to the business requirements? Do you have the technical and management skills and resources to make the company profitable? These details need to show up in the business plan you present to the bank. You need to prove in words and in numbers that you've got what it takes to run a profitable business.
Do you have the background and experience to run a successful business and if not, can you afford to pay for expertise that you may lack? The bank wants to see commitment, both personal and financial on behalf of the business owner, because no lender wants to finance the majority of any enterprise. Talk to the bank only when you can demonstrate a history of business processes and internal reports in ship shape.
Smart tip: Focus on the people and how their contributions make the business viable in tangible, measurable terms.
Strikes Against You
It's true, applying all over town for a loan can spell disaster for any business looking for credit. Lenders can find out how many institutions you've applied to by simply checking your credit bureau report. In the eyes of the lender, if you've sought credit from many places, it's not a good thing because it looks like you are desperate and probably not a good risk. Similarly, it's frowned upon if many collectors check your credit.
Smart tip: Don't shop around too much. Find a lender you like and trust and work with them to ensure your financial success. Pay your bills on time so collectors don't add detrimental information to your credit file.
Do You Qualify for a Loan?
Most banks measure your application against a rating scale. The score-sheet that determines if you are eligible for a loan is usually proprietary to the lending institution. Some lenders will explain how your application rated if you ask. If you fail to secure financing, make sure you find out why so you can stack the odds in your favour if you decide to re-apply.
Smart tip: If your loan application is rejected, ask why and re-apply when you can meet bank requirements.
Next in this series: Join us as we examine the ratios in greater depth and look at common balance sheet mistakes.
The information in this article was compiled with input from:
- Cathy Ierullo, Mississauga Area Branch Manager in Mississauga, and Lynn Wolverton, Account Manager, Business Development Bank of Canada (BDC);
- Rob Paterson, President and CEO, bizSmart; and
- Robert Gold, Managing Partner, Bennett Gold Chartered Accountants