Borrowing money from a bank to finance your business is a lot harder than getting a loan to buy a new car or to improve your home. Banks have a number of tough rules that you need to know before you approach them for a business loan, and these rules have become even more stringent in recent years.
So by understanding how banks make credit decisions, this can improve your chances of securing a business loan.
A banks main concern is protecting their capital and consequently bankers are generally very conservative. Their priorities are to recover the principal of the loan and earn a reasonable rate of interest on it.
Their third priority and your main is that your business prospers. Of course there is an ulterior motive as the banks would then want you to borrow further amounts from them.
(Their third priority and your main one is that your business prospers. Of course the bank will motivated by the prospect that your success is likely to mean that you return to borrow further amounts from them in the future.)
Ultimately, the safety of their loan is key! They are not in the business of unnecessary risk.
Your task is to provide the bank with as many reasons to feel confident in you as possible.
You should begin with planning out each aspect of your loan. Your proposal needs to include a description of how much you need to borrow and why, your up-to-date balance sheets, cash-flow figures and projections. Banks have their own forms to help you prepare these, but using your own business plan increases your credibility.
Ok, so we know that any loan process is based on Credit. A business loan is no different. So what do they look for? They will size up the proposition using the ‘Seven C’s of Credit’.
- Character: Personal character is crucial since all lending to small businesses are essentially ‘personal’ loans. The bank’s experience with you is critical. Their judgment on the character of an individual is based on past performance. Personal credit histories as well as business credit histories will be reviewed. It’s no mistake that this is the first ‘C’ on the list because basically it’s all about YOU and your continuing to be there is a vital element in the banks thinking. Demonstrate your ‘relevance’ and ‘validate’ yourself.
- Cash Stake: How much of your own capital are you investing in your business. If you are prepared to risk your own personal money in your business a banker will be persuaded that you are confident of success. How much this should be will depend on the proposition at hand but it needs to be large enough to show you are serious.
- Collateral: Collateral security is the ultimate fall-back position to assure the bank of the repayment of the loan. Banks want their loans repaid from your business profits so that your business thrives and you become a better customer. But just in case things go wrong some hard collateral always makes a bank lender sleep better at night.
- Capability: This is calculated on the amount of debt your business can reasonably support. The debt-to-net-worth (debt/net worth) ratio is often used to justify a credit decision. A highly geared business with a high debt/net worth ratio is perceived as less creditworthy than a company with low leverage (low debt/net worth).
- Conditions: Prevailing economic conditions strongly influence credit decisions. If the bank believes a recession is coming, it won’t be willing to lend easily.
- Credibility: Do you know your own business? Can you be relied upon to be level-headed? How credible are your plans? Are they just dreams or a carefully reasoned and researched plan with a high chance of success? A business plan helps you answer the banker’s questions without hesitation, sending your credibility rating soaring.
- Contingency planning: A contingency plan is a useful financing tool. Bankers like to see that you look ahead and have some forethought to potential difficulties. A contingency plan is a short worst-case business plan that examines the options that would be open to the business and how those options would be treated. It’s your ‘plan B’ that answers the ‘what happens if’ questions and shows how you would handle the recovery of say the death or serious health set back with a key member of your staff or a co-business owner. Decisions made in panic are poor decisions.
A contingency plan avoids panic (for you and your bank); so protect your profit generating people, they don’t appear on the balance sheet but they are vital business assets!
Banks and Risk
Banks are risk-averse by training and temperament. They don’t entertain the kinds of risks that a venture capitalist or private investor might look at; that isn’t their job. They tend to shy away from most start-up businesses. They hate surprises. This leads to misunderstandings between small-business owners and bankers.
Remember banks are themselves now subject to greater financial rigour and stress testing so they are now more cautious and risk conscious with prospective borrowers.
So why do bankers turn down loan applications? Except for bank credit reasons or legal reasons, applications are rejected for the following non-credit related reasons:
- Too little owner’s equity
- Poor earnings record
- Inadequate contingency plans
- Questionable management
- Low-quality collateral
- Slow/past-due trade or loan payment record
- Poor accounting system
- Start-up or new company
How to Get to Know Your Potential Finance Sources
Good lenders can be terrific assets to a business. The role of the bank or other lender should be to help you make your business successful.
But how do you find a good bank?
You can ask other business owners or better still your financial adviser or your accountant; good advisers proactively nurture good relationships with finance sources and can introduce you to the appropriate source.