Finance Your Own Business. Garrett Sutton
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Liquid asset verification and debt schedules for both the business and the principal owner
• Other pertinent information about the company and its principal owners
• A current year budget or projection may be requested
Once this information is received by the bank, a credit analyst will create a financial spreadsheet which displays the historical financial information in various formats, calculates numerous ratios and trends, and then compares the information to other companies of similar size in the same industry. You should request a copy of these spreadsheets whether your loan is approved or not, as there is often valuable information for your own consideration.
The financial spreadsheets are then sent to a loan officer for review and underwriting. If the loan officer determines that the request is eligible for consideration, the officer will compile a credit memorandum which summarizes the loan request, the financial condition of the applicant, variances from lending policy and risks associated with the request. The credit memorandum could be a few pages or longer than 100 pages, depending upon the size, nature and complexity of the loan.
Loan officers may have some direct authority to make a loan, but generally loan approval will require the signature of a credit administrator. If the credit request is larger, typically over $1 million or more, the loan request will need to be approved by a loan committee. In most cases, a loan which is approved by the loan officer and the credit administrator will rarely be declined by a loan committee.
Obtaining Loan Approval
The commercial loan underwriting process can be very complex and is beyond the scope of this book to fully describe. However, there are some basic financial data and ratios that are the key to obtain loan approval. The first is the amount and stability of historical and projected cash flow of the business. The second is the amount of debt and equity and available collateral for the loan. And lastly is the liquidity and financial strength of the principal owners of the business who guarantee the loan.
Loans are expected to be repaid from future excess cash flow, and thus the biggest issue for a loan officer to consider is if the cash flow is adequate to repay the loan. It is important to distinguish between net income and cash flow. A simplified approach, called Traditional Cash Flow method, will average the company’s prior three years of net earnings (net income), plus interest, plus other non-cash expenses like depreciation and amortization (this number is referred to as EBITDA). Using the EBITDA, the loan officer will calculate the current principal and interest payments of the existing debt, plus the principal and interest on the requested debt (this number is referred to as Debt Service). The loan officer calculates a debt service coverage ratio (DSCR) by taking EBITDA divided by Debt Service. This ratio should exceed 1.20. In other words, the company should show historically that it has 20% extra cash flow above the proposed loan’s payments.
Aside from the traditional historical cash flow, the loan officer will consider the trend of the sales and expenses and look for improving or declining cash flow. He will also review the balance sheet for other sources and uses of cash. Other uses of cash include such items as capital expenditures, and growth of accounts receivable and inventory relative to trade payables and other financing.
The second significant loan underwriting concern is the amount of debt and equity. The loan officer will calculate a debt to equity ratio by looking at the company’s total debt divided by the amount of equity. The total debt should be less than 4 times the equity. In other words, the company should have at least 20% equity. Equity provides a cushion above the debt which allows the company to be sold or liquidated and still be able to repay the loan.
The company’s assets are usually pledged as collateral for the loan. Collateral is a specific asset (or assets) which is pledged to the bank to secure repayment of the debt. For financially strong companies and guarantors, banks will make unsecured loans. However, most small business loans are secured by the company’s assets, such as its inventory, receivables and other fixed assets. In the event of default, the bank will have the right to repossess and sell the assets or collect the receivables to repay the loan.
The final consideration is the principal owner’s financial strength. In almost all cases, small business loans made by financial institutions will require the personal guarantee of any principal owner with 20% or more ownership of the company. If the business defaults on the loan, the bank will have the right to pursue the owner of the company. Loan approval considers the liquid assets, personal cash flow and overall net worth of the principal owner, especially if the primary cash flow and collateral offered by the business are not sufficient. The bank may ask that the principal owner pledge additional collateral to support the loan if the company’s assets are not adequate collateral for the loan
What If The Loan Is Declined?
If your loan request is declined, you are entitled to be told specifically why you have been declined. The best strategy is to meet face-to-face with the loan officer and discuss the specific reasons for the decline. You should inquire about what changes or benchmark ratios need to be improved to obtain a loan.
If the loan officer is not an SBA loan specialist or the bank is not an active SBA lender, you should meet with the SBA officer or locate the most active SBA lender in the community. The SBA guarantees a significant portion of the loan principal (up to 90%) and many banks and other non-bank financial institutions will make loans declined by banks. You should also go back to some of the resources mentioned in this book and begin searching for alternative lending sources. There are many sources of financing available and strategies to become “bankable” if you search for them.
Thank you, Tom, for your valuable insights.
We will discuss SBA loans in the next chapter. But first, it is appropriate to provide several more tips for dealing with banks, or any lender for that matter.
Where Do I Stand?
If the numbers and formulas we’ve been describing in this chapter make your head spin or your eyes cross, you may check out a couple of simple tools that can help you (and lenders) handle your businesses’ overall financial health.
Sageworks is an internet company that develops products that can be used by small businesses, accountants and other financial advisors, as well as lenders, to evaluate the financial health of a business. According to Sageworks, there are five main financial statement ratios that creditors frequently use to evaluate the financial performance of a private company. They are:
• Cash to Assets
• EBITDA to Assets
• Debt Service Coverage Ratio
• Liabilities to Assets
• Net Income to Sales
With the Sagework platform, eight to ten pieces of information can be entered to produce a report that will help evaluate the businesses’ financial statements and analyze what they are doing well, as well as what areas may need improvement.
“Some businesses will run these reports to see where they stand before they talk to a banker. It’s a quick proxy for what will I hear from my bank?,” says analyst Libby Bierman. But a business owner can also use it, “for leverage or to negotiate for better payment terms,” she says, if the financial health of the business is strong. For more information, including free whitepapers on business credit topics, visit our Resource Section.
Dress for Success
It should almost go without saying that when you meet with a banker or other lender you should dress appropriately. We’ve added the word ‘almost’ to that last sentence in recognition of how informally people conduct themselves now. Most of you know how to dress. But clearly—the evidence is all around us—some people don’t. So while we don’t want to come across as a nag or a scold, if your idea of formal is a T-shirt without holes in it, we have some work to do. The point of this book is to get your business financed. You’ve got to use every strategy and tactic to get it done. Show the lender some respect by dressing appropriately. (For an entertaining and interesting perspective on this topic, read Crazy Egg founder