It is quite a process when you apply for a business loan at the bank or credit union. A lot of business owners think that financial institutions are asking for the world when they try to apply for a loan. Some people still remember their mortgage application process few years ago when “no income” and “no documents” loans were the norm. Those usually feel frustrated when they are applying for a business loan today. I’ll give you a few tips of advice about what you should know and look for when applying for a easy business loan.
First of all you have to put yourself in a financial institution’s position for a minute. Bank or credit union is in the business of lending not investing, which means none of the financial institutions will be excited about your start up or business that’s been around for less than three years. You do need track record of stability and historical cash flow to prove that business does have and will have the ability to repay the loan. This leads us to the most important factor in this process – cash flow.
Cash flow and debt service coverage. Positive cash flow, profit, surplus whatever you call it is the most significant aspect of your loan approval process. If your business is able to demonstrate last three years of profit on paper 50% of the approval is done. Pay attention that I said it has to be on paper – federal tax returns, accountant or CPA reviewed or in some cases audited financial statements are what counts. Don’t try to give a story, “oh, my business is making money but I don’t show it on paper” or “I don’t have my federal tax returns and I am definitely not getting reviewed or audited financials”. Those two statements will get you a quick decline. To measure positive cash flow and repayment ability financial institutions use a ratio called debt service coverage (DSC). Business needs to show at least two to three years of 1.25x DSC. DSC is calculated as followed annual net operating income (NOI) plus depreciation, amortization and interest divided by total business annual debt service. For example if business NOI wit add backs is $375,000 and the total amount to make payments on business debts is $265,000 the DSC will be 1.42X which is good. There are also plenty of other ratios and test methods but DSC tends to be the key when it comes to small business lending.
Collateral can be as important as cash flow and DSC. In most cases even if you show the last three years of DSC greater than 1.25X but you lack collateral the loan can get declined. Usually when bank says collateral they mean real estate or industrial equipment and machinery. Business good will, account receivables, contract assignment, inventory or office equipment is not the most desirable collateral. Strong cash flow always has to be followed by strong collateral. On occasion you might find some lenders that will grant you a loan with the lack of cash flow but strong collateral and low LTV. The business might be showing one or two years of losses but if LTV is at 40% or less some lenders might approve the loan for a business that’s been in existence for a while. Typical LTVs are up to 80% on owner occupied real estate and up to 75% on investment real estate. Vacant land for which loans are scarce these days can be financed for up to 50% LTV. On brand new industrial machinery and equipment you can expect up to 80% LTV, on used up to 60%.
Personal guaranty. Requirement of owners’ personal guarantees is expected for most of the privately owned companies. If your business is generating $50 million or less in annual revenue most of the time business owners (anyone owning 20% or more of the business) will have to pledge personal unlimited and unconditional guaranties. For a public company or business generating close to $100 million in revenue personal guarantees can be limited or completely waved. Once in awhile an owner of newly established company makes the statement, “I am not providing my personal guaranty, that’s why I’ve created corporation or LLC” Those get quick answer “No”. There is just no way around it if you want the loan.
Business credit history is one of the urban myths. Usually newer businesses are very concerned about their business credit history. Let me tell you that this is probably one of the last things bank is concerned about when you apply for a business loan. Your personal credit history is even more important than business credit history. And believe in business lending “no income verification and no document” loans do not exist so don’t sweat about your business credit score.
As part of the due diligence lender will check for pending litigations, outstanding judgments, collections or tax liens. None of that better show up because even if you have strong cash flow and solid collateral the loan will get declined. In case you are not applying or applied and got denied with your current bank don’t bad mouth them and have a good explanation of why you are not applying with them or why you got declined.
To summarize it all as long as you have strong cash flow and collateral you should be OK. If you are not getting what you need with your bank try others. There are tens of thousands of banks and credit unions in United States and you can find the list of your local financial institutions by visiting websites. Try not to use brokers unless you have no time to shop around because all brokers do is the same as you would do – just call around from one bank to another. Some financial institutions are even shying away from broker solicited loan requests because they don’t have a chance to learn more about the borrower themselves. In these challenging economy times a lot of businesses tend to have more success when applying for loans at their local community banks or credit unions.