Three Things to Consider Before Applying for a Business Loan

All businesses require capital to grow, expand their geographic footprint or product offerings, or simply to provide the cash needed to finance their normal operating cycle. Many small businesses are funded initially by using the entrepreneur’s savings or other assets. But as companies grow, most will at some point find it beneficial to source debt capital to support their operations. While sufficient equity capital is fundamental to a sound balance sheet, leveraging this equity with bank debt is usually appropriate when done prudently.

Create an Effective Business Plan

Before a business considers the types of loan it needs to support its operations, a business first must create a business plan that demonstrates to the bank the company’s clear understanding of the financial impact of its initiatives. When the company’s plan contemplates bank debt, the company would be wise to address in its plan what lenders refer to as “The Five Cs of Lending.” These are the foundation upon which banks make good credit decisions. Your business plan should provide information about each of the following:

  • Character: Your business plan should provide references, credentials, and a proven track record of how your company has met its obligations. Lenders want to work with borrowers who take their financial obligations seriously and who take responsibility for their debts. Think of Character as the lender’s way of asking, "Will you repay the loan?"
  • Capacity: Include information about your company’s borrowing history, track record of payments, sales projections, and most importantly cash flow projections. Lenders also look at the level of debt to equity and to cash flow and liquidity (how quickly can the company’s current assets be converted into cash). Capacity answers the question, "Can you repay the loan?"
  • Capital: Funds invested in, and retained by, a company show the level of financial commitment of the owners. More equity results in lower leverage and reduces the financial strain on the company’s balance sheet when times are tougher.
  • Conditions: Current market and economic conditions are a major factor in loan approval. Your company’s business plan should address a downturn in the economy and cash flow projections should be stressed in multiple ways to illustrate that the company can repay the loan even in deteriorating conditions.
  • Collateral: Bankers require that loans have solid primary and secondary sources of repayment. For lines of credit, the primary source of repayment is conversion of current assets (e.g., inventory or accounts receivable) to cash. For term loans, the primary source of repayment is cash flow from operations over multiple operating cycles. In each of these types of loans, collateral provides a reasonable secondary source of repayment. For lines of credit, the bank would require accounts receivable and inventory to be pledged as collateral. For term loans, the pledge of longer-lived assets (e.g., equipment or real estate) would be required. Here’s an important point: The bank never wants to rely on a secondary source of repayment, because it rarely will liquidate the loan in the event of a default. If the bank has any concern that the primary source of repayment will not repay the loan as contemplated, the loan will not be made.

Establish Lines of Credit for Short-Term Needs

Sourcing the right amount and structure of bank debt are both critical. Using short-term bank debt in the form of lines of credit is appropriate to finance timing differences during the company’s operating cycle – the process of converting short-term assets, like inventory and accounts receivable, to cash. Banks will provide short-term financing when the need for cash to invest in new short or longer-term assets exceeds the collection of cash from the sale of inventory and the collection of the accounts receivable resulting from those sales.

Lines of credit can provide, along with equity capital provided by the owners and earnings retained in the business, the cash needed for liquidity to meet current obligations, like accounts payable and payroll. Just like in their evaluation of whether to grant any type of credit to a business, banks will want to make sure that borrowing under these credit facilities will not create a financial strain on the company. So, the bank will require prudent advance rates on the assets financed and will closely monitor the company’s ability to turn inventory and collect receivables.

Typically, short-term financing is provided through lines of credit with maturities of one year, that are renewable annually. Borrowings under such facilities are typically self-liquidating, that is, they are repaid from the routine conversion of non-cash short-term assets (accounts receivable and inventory) to cash.

Consider Term Loans for Longer-Lived Assets

Longer-term financing is used by companies to finance assets that have a longer life (like equipment or company vehicles), or to expand the company’s business (such as building a new plant or headquarters building), or to make acquisitions. These loans have a different source of repayment from lines of credit because they are repaid from cash flow over multiple operating cycles. So, these type loans have longer maturities (3-5 years), and the loan is typically repaid with monthly payments of principal and interest.

Running a business is complex.

Working with a financial partner who understands your business needs can be a game changer when it comes to optimizing your business cash flow. Your time is money and you deserve a financial partner that is driven by your business goals.

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