Character: Although you will never receive a loan based on your character only lenders will consider it. Lenders will try to gauge your experience and knowledge of the industry you compete in. They will try to judge how responsive you will be as a manager to changes and unexpected problems. Community service, reputation and what the bank already knows about you as a borrower will all determine how they judge your character. If your deal is marginal, meaning it could easily be approved or declined; your character could swing the decision. The lenders want to be comfortable with their borrowers. Just because you have the ability to pay the lender back doesn’t mean that you will.
Credit History: Your FICO score measures and defines how you have handled credit in the past. It is often argued to be an ineffective way to measure credit worthiness of a borrower. Whatever your opinion is of the FICO score, the fact is you should strive to maintain a good score. Your FICO will determine your approval or denial of credit if you are pursuing credit under a $100,000. Loan requests under this threshold are treated more like a personal credit request (i.e. if you meet a box of criteria you’ll be approved).
Once you begin to borrow more than $100,000 the lenders typically will review your loan request in greater depth. As a result more is considered in the credit decision. You will find that while it is important to have a good FICO score it will not be the major factor considered. In these cases a lender will inquire specifically about items on your credit report for an explanation. I have seen loans approved where FICO scores have been in the mid 500’s. Don’t assume that a poor FICO will make you unworthy of credit. Discuss it openly with your lender and find out if your request has other strengths that will offset concerns with your credit score.
Lenders will review payment history, types of accounts and balances on revolving credit lines, judgments, liens, the length of time accounts have been established and anything else adverse. The more history you have on your report the more valid the FICO score will be to the lender. If you have a 750 FICO score but only have a credit card and a student loan, chances are good they will discount the score’s accuracy. It’s a good idea to pull your credit report before you request a business credit so that you are prepared to discuss any concerns that may exist.
Collateral: The first thing you need to know about collateral is that your lender will always discount the value of it to meet their credit policy. Although you may purchase a piece of equipment for $100,000 and put it on the books as an asset for the purchase price, a lender will typically discount used equipment by 25%-50% depending on the equipment and the lender. Lenders do this to determine a liquidation value for the assets of your business. If your business fails, the liquidation values of the business assets represent the cash the bank can expect to receive to repay the loan. For this reason a lender will never give you 100% value for collateral. It will always be discounted.
Some lenders will issue loans that are under collateralized (meaning they are not 100% covered by the liquidation of the assets). These lenders are rare to find and you must present other strengths in the loan request to get an exception on collateral. Other lenders will over collateralize loans with primary and secondary sources. These lenders may want to secure personal residences and other assets. You will want to discuss this with your lender before you go through the loan process. This could save you time and headaches in the long run.
Here is a list of collateral in order of liquidation value lenders will typically assign.
Collateral Liquidation Value
-Real Estate 75%-80% of value
-Tangible Equipment 50%-75% of current market value
-Accounts Receivable 50%-80% depending on the lender
-Computers and Software 0%
-Goodwill or Patents 0%
Lenders will also consider how difficult it will be to liquidate or access the collateral in the event of default. Current values of assets will also be valued at market and economic conditions (i.e. Real estate in 2007 was worth more than it was in 2009). Knowing what collateral you have for the lender will help determine how much money your business will be able to borrow.
Capacity: Capacity represents your ability to repay the loan. Often capacity is measured by looking at “cash flow” and “net discretionary income.” I’ll evaluate both of these measures for you. By understanding these two measurements you will know how strong your credit request is because you will know how to pay it back.
Cash flow is a measurement focused on the business. Cash flow tells the lender what is available to pay back the loan request. Cash flow is sometimes referred to as “Earnings Before Interest Tax Depreciation and Amortization” (EBITDA). One-time capital expenditures can also be added back to determine a true cash flow picture of your business. When you take cash flow (EBITDA) and divide it by your total debt payments you get a figure that tells you how many times you can pay your debt (Debt Service Coverage). Lenders will use this to determine how well you could repay the debt on an annual basis. This number must be above 1.25 to be considered for a loan. (See the Basic Accounting Ratios section of this guide Debt Service Coverage for more information about this ratio.)
Net Discretionary Income is used to determine what personal income is left after a living allowance and personal debt. What is left can be used to pay the business debt request. This can supplement a shortfall in business cash flow if necessary. (See the Understanding Cash Flow and Net Discretionary Income section of this guide for more detail.)
Conditions: How is the economy currently affecting your business? What does your competition look like and how do they impact sales? Are there any borrower profiles that pose a potential risk to the business or loan repayment? These and other questions are examples of what lenders will be trying to answer with respect to your business performance. The conditions should outline the “Borrowing Cause” already discussed. This will help the lender determine how your loan must be structured. Most of the other C’s of credit look at your business from a microscopic view. The conditions represent the macro view of your business and how it fits in the current environment. This picture must check out as well.
Make sure you understand the competitive landscape of your business and how the economy is affecting you. Have a plan for potential weaknesses and be able to justify how you will overcome them. This is an opportunity for you to demonstrate that you’re “business savvy.” Do not leave this rock unturned in your preparation for a loan.
Capital: Bankers will review both cash in the business and personal cash on hand for strength in your loan request. Some lenders like to see 3-6 months of working capital in you bank account. This money is considered back up incase you experience a dip in sales or some other problem in the business. This safety net provides the lender a sense of comfort in your ability to save and plan for future contingencies. A business owner that pulls all the money out of the business and spends it is a potential risk.
Cash in a bank account is easily accessible and can be used in emergency situations without penalties. Cash in a retirement account is more difficult to access and usually has penalties for early withdrawal. Lenders will discount cash available in these types of accounts. The liquidity ratios defined in the Basic Accounting Ratios section of this guide will provide you examples of some measurements the lender will evaluate. Compare these ratios with the industry standard to see how you rate against your peers. This is what your lender will do when they evaluate business capital.
There is not a magic amount of cash you need to have on hand to get a loan done. I have seen loans granted when hardly any cash was present. If you generally follow the rule of keeping 3-6 months of working capital in cash on hand, and you save a reasonable amount of cash each year from business profits; you should be able to demonstrate sufficient capital to the lender.