Borrowing Money

Borrowing money is one of the most common sources of funding for a small business, but obtaining a loan isn't always easy.  Before you approach your banker for a loan, it is a good idea to understand as much as you can about the factors the bank will evaluate when they consider making you a loan. This discussion outlines some of the key factors a bank uses to analyze a potential borrower. Also included is a self-assessment checklist at the end of this section for you to complete.

KEY POINTS TO CONSIDER
Let's begin by exploring some of the key points your banker will review:

1. Ability to Repay/Capacity
The ability to repay must be justified in your loan package. Banks want to see two sources of repayment -- cash flow from the business, plus a secondary source such as collateral. In order to analyze the cash flow of the business, the lender will review the business's past financial statements. Generally, banks feel most comfortable dealing with a business that has been in existence for a number of years because they have a financial track record. If the business has consistently made a profit and that profit can cover the payment of additional debt, then it is likely that the loan will be approved. If however, the business has been operating marginally and now has a new opportunity to grow or if that business is a start-up, then it is necessary to prepare a thorough loan package with detailed explanation addressing how the business will be able to repay the loan.

2. Credit History
One of the first things a bank will determine when a person/business requests a loan is whether their personal and business credit is good. Therefore before you go to the bank, or even start the process of preparing a loan request, you want to make sure your credit is good.

First get your personal credit report. You can obtain a report by calling Trans Union, Equifax, TRW or another credit bureau. It is important that you initiate this step well in advance of seeking a loan. Personal credit reports may contain errors or be out of date. In many cases, people find that they paid off a bill but that it has not been recorded on their credit report. It can take 3 to 4 weeks for this error to be corrected -- and it is up to you to see that this happens. You want to make sure that when the bank pulls your credit report that all the errors have been corrected and your history is up to date.

Once you obtain your credit report, how do you know what it says? Many people receive their credit reports yet have no idea what the strange numbers signify. The following should help in interpreting and checking your personal credit report.

First, check your name, social security number and address at the top of the page. Make sure these are correct. There are people who have found that they have credit information from another person because of mistakes in their identification information.

On the rest of your credit report you will see a list of all the credit you have obtained in the past - credit cards, mortgages, student loans, etc. Each credit will be listed individually with information on how you paid that credit. Any credit where you have had a problem in paying will be listed towards the top of the list. These are the credits that my affect your ability to obtain a loan.

If you have been late by a month on an occasional payment, this probably will not adversely affect your credit. However, if you are continuously late in paying your credit, have a credit that was never paid and charged off, have a judgment against you, or have declared bankruptcy in the last 7 years, it is likely that you will have difficulty in obtaining a loan.

In some cases, a person has had a period of bad credit based on a divorce, medical crisis, or some other significant event. If you can show that your credit was good before and after this event and that you have tried to pay back those debts incurred in the period of bad credit, you should be able to obtain a loan. It is best if you write an explanation of your credit problems and how you have rectified them and attach this to your credit report in your loan package.

Each credit bureau has a slightly different way of presenting your credit information. You can get specific information on "how to read the report" form the appropriate company, but here's a few tips to get you started:

TRW
In the last few years TRW has prepared credit reports with words and not numbers. Good credits should read "Never Late", "Paid as Agreed". Poor credits will read as

Trans Union
On the right side of the page on the credit report are number and letter combinations. "I" means installment credit. "R" means revolving credit. The key information is in the numbers. A "1" means perfect credit since you have always paid your bills on time. "2" or "3" means you have been 2 to 3 months late in paying your bills. Too many of theses will hurt your chances in obtaining credit. A "9" means delinquency in paying your bills and a charge off. This could make it difficult in obtaining a loan.

If you need assistance in interpreting or evaluating your credit report you can ask your accountant or a friendly banker. If your credit report has a few problems on it, you may find that another bank may evaluate your credit report differently.

3. Equity
Financial institutions want to see a certain amount of equity in a business. Equity can be built up in a business through retained earnings or the injection of cash from either the owner or investors. Most banks want to see that the total liabilities or debt of a business is not more than 4 times the amount of equity. (Or stated differently, when you divide total liabilities by equity, your answer should not be more than 4.) Therefore if you want a loan you must ensure that there is enough equity in the company to leverage that loan.

Don't be misled into thinking that start-up businesses can obtain 100% financing through conventional or special loan programs. A business owner usually must put some of her/his own money into the business. The amount an individual must put into the business in order to obtain a loan is dependent on the type of loan, purpose and terms. For example, most banks want the owner to put in at least 20 - 40% of the total request.

Example: A new business needs a $100,000 to start. The business owner must put $20,000 of her own money into the new business as equity. Her loan will be $80,000. The debt to equity ratio is 4:1. Note also that this is only one of many factors used to evaluate the business -- just having the right debt/equity ratio does not guarantee you'll get the loan.

The balance sheet indicates the amount of equity or net worth of a business. The net worth of the business is often a combination of retained earnings and owner's equity. In many cases, owner's equity will be shown as a loan from shareholders and therefore a liability. If a business owner wishes to obtain a loan, she will be obligated to pay the bank back first and not herself. Consequently, it may be necessary to restructure the liability so that it becomes owner's equity or subordinate the loan. If the current debt to net worth is 4 or over it is unlikely that the business will be able to obtain additional debt/loan. For more information on understanding your balance sheet, check out Understanding Financial Statements.

4. Collateral
Financial institutions are looking for a second source of repayment, which often is collateral. Collateral are those personal and business assets that can be sold to pay back the loan. Every loan program, even many micro loan programs, requires at least some collateral to secure a loan. If a potential borrower has no collateral to secure a loan, she/he will need a co-signer that has collateral to pledge. Otherwise it may be difficult to obtain a loan.

The value of collateral is not based on the market value. It is discounted to take into account the value that would be lost if the assets had to be liquidated.

The following table gives a general approximation on how different forms of collateral are valued by a typical bank and the SBA:

COLLATERAL TYPE	BANK	SBA
HOUSE:	Market Value x .75 - Mortgage balance	Market Value x .80 - Mortgage balance
CAR:	nothing	nothing
TRUCK & HEAVY EQUIPMENT:	Depreciated Value x .50	same
OFFICE EQUIPMENT:	nothing	nothing
FURNITURE & FIXTURES:	Depreciated Value x .50	same
INVENTORY:   Perishables	nothing	nothing
JEWELERY	nothing	nothing
OTHER	10%-50%	10%-50%
RECEIVABLES	Under 90 days x .75	Under 90 days x .50
STOCKS & BONDS	50%-90%	50%-90%
MUTUAL FUNDS	nothing	nothing
IRA	nothing	nothing
CD	100%	100%

COLLATERAL COVERAGE RATIO
The bank will calculate your collateral coverage ratio as part of the loan evaluation process. This is calculated as follows:

Total Discounted Collateral Value
Total Loan Request

5. Experience
A client that wants to open a business and has no experience in that business should not seek financing let alone start the business unless they intend to hire people who know the business or take on a partner that has the appropriate experience. Regardless, the client should be advised to take some time to work in the business first and take some entrepreneurial training classes.

QUESTIONS YOUR BANKER WILL ASK

The key questions the banker will be seeking to answer are as follows:

1. Can the business repay the loan? (is cash flow greater than debt service?)
2. Can you repay the loan if the business fails? (is collateral sufficient to repay the loan?)
3. Does the business collect its bills?
4. Does the business control its inventory?
5. Does the business pay its bills?
6. Are the officers committed to the business?
7. Does the business have a profitable operating history?
8. Does the business match its sources and uses of funds?
9. Are sales growing?
10. Does the business control expenses?
11. Are profits increasing as a percentage of sales?
12. Is there any discretionary cash flow?
13. What is the future of the industry?
14. Who is your competition and what are their strengths and weaknesses?.

SELF-ASSESSMENT CHECKLIST
Whether you are applying for a micro loan, SBA loan or a traditional bank loan, there are certain factors that improve your ability to obtain financing. The following is a simple checklist to do before you begin to seek capital.

Do you have a good personal credit history?

Yes

No

Research indicates that good personal credit history is one of the most important factors in identifying borrowers that will repay their commercial loans. Many loan programs require perfect personal credit in order to qualify. For further information refer to Key Points to Consider - Credit History.

Have you filed all income tax returns?

Yes

No

Lenders and government loan programs alike want to see that an individual has met their tax obligations for both filing and paying taxes. For SBA loans tax verification is obtained from the IRS before a loan is closed.

Are your Income Taxes paid?

Yes

No

Many of the loan programs are in partnership with government agencies. These loan programs do not look favorably on individuals who have unpaid income taxes.

Does the business have the ability to repay a loan?

Yes

No

(For existing businesses) If the business is profitable, then there are demonstrated profits to repay some amount of new debt. If a business is not profitable, then it becomes very important to prove how it will be profitable in the near future so that a loan can be repaid.

(For start-up businesses) It is very important that you find as many data on comparable businesses or industry statistics in order to "prove' the revenues you intend to generate and the expenses you anticipate incurring.

Does your business have a positive net worth?

Yes

No

(For existing businesses) The net worth of the business should be positive. If there are loans from shareholders on the balance sheet and you are able to subordinate these (not pay the shareholders) while you pay the bank loan back, you may consider these loans from shareholders as equity.

Is your business not carrying too much debt?

Yes

No

(For existing businesses) Businesses that have too much debt will find that their profits are directed at paying back loans and not building retained earnings in the business that can fund future growth. Consequently, banks and government loan programs look more favorably at loan requests that do not add too much debt to the business. Banks often look for a debt to net worth ratio of 4 or less (total liabilities divided by equity).

Do you have enough of your own money in the business?

Yes

No

(For start-up businesses) All loan programs require that the business owner put their own money in the business. This owner equity injection shows that the owner believes in the business enough to risk their own money. Some micro loan programs require only 10% owner equity, other programs require at least 30% and will look more favorably on a loan request the more equity is in the business.

Do you have collateral to secure a business loan?

Yes

No

Business and personal assets can be considered collateral, or a way to repay the loan if the business defaults on a loan. Most collateral is valued at an amount less than face value based on a variety of factors.

Are you willing to personally guarantee a loan?

Yes

No

Most business owners are asked for a personal guarantee in order to obtain their first business loans.

Does your business have qualified managers and advisors?

Yes

No

(For existing businesses) As businesses expand, they need more sophisticated management as it relates to strategic planning. marketing, record keeping, inventory control, personnel, etc. When you apply for a loan, your banker will consider the qualifications of your management team and advisors in order to determine if they are capable of leading your business to the next level of growth.

If there are sectors of your business that you need assistance with, we strongly recommend that you attend entrepreneurial training classes, visit a women's business assistance center or Small Business Development Center in your area, or contact your regional SBA office for information on local resources.

Do you have experience in running your own business?

Yes

No

(For start-up businesses) For a new business especially, it is important for the business owner to demonstrate that she has experience in the industry and/or entrepreneurial experience. If you have never owned or operated a small business before, we strongly recommend that you attend entrepreneurial training classes.

STOP! If you cannot answer yes to all the questions above, then you may have difficulties obtaining financing at this time. We suggest that you evaluate the needs of your business and take advantage of local business assistance centers.

(Women's Business Development Corporation, Chicago, IL, 4/97)