SMALL BUSINESS DEVELOPMENT CENTER RM. 032

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1 SMALL BUSINESS DEVELOPMENT CENTER RM. 032 FINANCING THROUGH COMMERCIAL BANKS Revised January, 2013 Adapted from: National Federation of Independent Business report Steps to Small Business Financing Jeffrey Timmons book, New Venture Creation Funded in part through a cooperative agreement with the U.S. Small Business Administration. All opinions, conclusions or recommendations expressed are those of the author(s) and do not necessarily reflect the views of the SBA. Commercial banks are the most visible lenders and make the greatest number and variety of loans. According to a report by the National Federation of Independent Business, 85% of loans to small businesses come from banks. However, banks are generally considered conservative lenders. Their loan committees need to be convinced of your ability to repay the loan based on profit projections, management expertise, market strength, and your personal record. Develop a good working relationship with a banker before asking for a loan. Involve him/her in planning for your business and make them familiar with those involved. This can ease the loan request. This guide looks at how loans come in many forms and how some are more appropriate for your needs than others. Our guide Alternative Financing Sources For Your Small Business looks at methods to finance your business other than through commercial banks. The following types of loans are available from most financial institutions. Decide which satisfies the needs of your business. Short Term Loans: Line of Credit (Revolving Line of Credit) - an agreement with a financial institution which promises to lend up to a certain amount without requiring you to file another loan application. You can repay and re-borrow as often as you need. At the end of the year, the loan should generally be paid up and the line of credit may be renewed. Usually must be secured by collateral. Allows you to maintain an even cash flow to operate your business. This can tide you over until a customer pays a big bill or allows you to take advantage of supplier discounts. Seasonal Line of Credit - there are times in the business when you need extra capital to prepare for a seasonal product or hold you over the slow months. The period between income generation may be lengthy, but you need to keep operating. Don t borrow more than you need. This kind of loan is expected to be repaid within a year. Intermediate Term Loans - these loans may run as long as three years. Consider this type of loan for business start-up, the purchase of new equipment, the expansion of a store or plant, or an increase in working capital. Usually repaid in monthly or quarterly payments from the business profits. Loan usually requires collateral. Long Term Loans - typically runs for more than three years, is usually secured, and may be granted for business start-ups, purchasing major equipment, moving a plant or store, or for other purposes. Repaid on a monthly or quarterly basis out of cash flow or profits. The loan agreement may contain provisions which limit your business s other debts, dividends, or principals salaries or require that a percentage of the profits 1

2 be used expressly to repay the loan. Collateral for a long term loan may be the assets you are purchasing, supplemented by your personal guarantee, stocks, bonds, certificates of deposit, other personal assets or other business assets. Commercial Mortgages - you will need this if you plan to buy, build, or expand your business, building, or obtain needed land. The mortgage is usually made for up to 75 to 80 per cent of the appraised value of the property and is amortized over a set period of ten to twenty years. The bank may require an independent appraisal at the customer s expense. If you need cash, property that your company now owns may be mortgaged. If property, land, or buildings are already mortgaged, you may be able to obtain a second mortgage. The interest rate on the first mortgage should not be affected by the second one. The interest rate on the second mortgage would most likely be higher than the rate of the first mortgage. Letters of Credit - not an actual loan but similar to an application for a loan and is treated the same way. Letters of credit are often used to facilitate business transactions. Document issued by the bank guaranteeing payment (of a stated amount for a specific period) to the seller of the amount negotiated by the buyer. CHOOSING A LENDER The cost of financing is an obvious factor in selecting a bank. Different financial institutions may offer different rates because of variations in their cost and availability of funds. Some banks will charge fees, such as an origination fee. Fees will usually be quoted as a percent of the amount of the loan request called a point. So a 1% fee on a $100,000 loan would be $1000 or one point. Fees can be financed from loan funds or paid from the borrower s existing funds. Either way, these fees add to the cost of financing. Check to see if maintaining a minimum balance or a compensating balance in another account will result in a lower rate. Many banks may offer only variable rate financing or both variable and fixed rate loans. With variable rate loans, the interest rate will be tied to some economic index, and the rate on the loan will change to correspond with increases or decreases in the index. The quality of service is another important factor in your bank selection. Find out if the bank you are considering makes a specialty of lending to small businesses. Also, it is helpful to know if the bank participates in the U. S. Small Business Administration programs. Check with other small business owners in your industry or region to find out which banks they highly recommend or if the bank has a history of serving your kind of business. Ask your lawyer or family or friends for recommendations. Make sure that the bank also has a full range of services that you need, such as cash management, investments, trust, etc. Do not overlook the bank or banks you currently deal with. You already have a personal relationship land familiarity with each other. Finding the right bank is important so interview several bankers. APPLYING FOR A LOAN Lenders typically use the five C s criteria when determining whether or not to lend money. The Small Business Administration outlines borrowing requirements at its website Jeffrey Timmons, author of New Venture Creation explains it this way: 1) Character. Character means that when the borrower promises to repay a loan, he or she means it. Further, the borrower has the ability and will do everything he or she can to conserve business assets and repay the loan. 2) Capacity. This C addresses whether the borrower has the capacity to use the loan and create the business growth it projects. 2

3 3) Capital. Most financial institutions will require that you produce a minimum of 20-30% of the total estimated cash needed for start-up costs. This is referred to as your owner equity/investment in the business. A lender will want to see an adequate amount of equity capital from insiders or outsiders or both, who invested in the business. First, cash investments by the lead entrepreneur or other founders are evidence of their faith in the future of the business. Second, a lender will look for sufficient equity capital (e.g. that gives a debt-to-equity ratio of no more than one to two) so the lender can safely retain his or her position. Without sufficient equity capital, the lender can essentially become a very unwilling shareholder, a position he or she does not want to be in. 4) Conditions. Conditions are what change for the worse after you extend the credit. Primarily, consideration of conditions involves whether general business conditions and those within the specific industry of the borrower are such to give the lender cause for concern or optimism. Included in these considerations are the nature of the borrower s product and its competitive position in the marketplace. 5) Collateral. This C involves the decision about whether or not the loan is to be collateralized and, if so, with what. The lender will consider if he or she forecloses on the collateral, to whom can it be sold, and for how much its sale at auction can recover. Entrepreneurs with new or early-stage businesses generally will be required to back their loans with all of the assets of their business, key-man life insurance payable to the bank, and personal guarantees. Also, the larger the loan compared to net worth, the more important is the issue of collateral and the value of the collateral. In addition to the five C s, the lender will require such items as a loan proposal, personal information, and financial statements. Loan Proposal - This is a written statement which describes your business and its history, spells out how you will use the loan, and how you plan to repay the loan. One could describe the loan proposal as a document that factually makes the best case for granting the loan. Personal Information Today s lender will look heavily at your credit score. For information on credit history and how it might affect your ability to secure a loan, see the sba site In some cases, personal tax returns for the past three years may be requested. Financial Statements - These statements should describe the condition of your business. All of this information should be presented in generally accepted financial reporting forms which allow the data to be easily understood. Your statements should include: Balance Sheet - from most recent fiscal year ended. Income Statement - statement showing profit and loss for last three years, up to the current fiscal year end. Cash Flow Projections - projections showing how much cash will be generated in the future to repay the loan. Accounts Receivable & Accounts Payable Agings - these reports break out receivables and payables in 30,60,90 and past 90 day old categories. Ratio Summary - this report summarizes key ratios which reflect on the financial condition of the business. FINANCIAL RATIOS Every lender tries to understand the condition of the borrower s business. Below are some of the measurements that are of interest to bankers to determine the strengths of your company. Most of these ratios can be compared to industry averages through a service provided by Robert Morris & 3

4 Associates. Ask your banker or accountant to provide you with industry averages for your particular industry. This will give you an idea of how you compare to the competition in your industry. Liquidity - The amount of cash and working capital a company has is a good indicator of how efficiently your business generates internal cash flow to repay the loan. Quick Ratio - a simple reading of short term liquidity. Quick Ratio = Cash + Accts. Receivable + Marketable Securities Current Liabilities Current Ratio - inventory is included because it is the least liquid of all current assets or can t be turned into cash easily. Current Ratio = Current Assets Current Liabilities Leverage - The amount of debt on a company s balance sheet, when compared to the amount of equity in the business will give the banker an idea of how leveraged the business is. Debt to Net Worth - measures the extent to which the firm relies on borrowed funds and provides an indication of ability to repay. Debt to Net Worth = Total Debt Net Worth Debt to Total Assets - the ability to repay a long term debt. Debt to Total Assets = Total Debt Total Assets Inventory - your banker will want an accurate count of your inventory, particularly if you are running a wholesale or retail operation. An accurate inventory count will help determine inventory turnover. To calculate inventory for a particular period, the following formula can be used: Inventory = Inventory (in $) at Beginning of Period + Purchases - Cost of Goods Sold Inventory Turnover - valuable in monitoring internal operations and provides a useful background for a financing plan. This ratio helps you achieve the right balance between overstocking and understocking. If you re overstocked, you re paying interest on working capital and paying for inventory. If you re understocked, you could have a loss of sales. Inventory Turnover = Cost of Goods Sold Average Inventory Receivables Turnover and Average Collection Period - measures the amount of accounts receivable in relation to sales. If your credit is too liberal, your carrying costs are higher than necessary. You must collect receivables within a reasonable time for them to remain a liquid asset. When measured against industry standards, this ratio will tell you if your receivables are high, on target or low. If low, it might mean that your credit policy is too liberal or your collections method is lax or both. If high, your collection procedures may be too harsh. Receivables Turnover = Net Credit Average Receivables Average Collection Period - this ratio should bear a strong resemblance to your payables schedule. If most of your creditors ask you to pay within 10 days, but your Average Collection Period is 45 days, you ll most likely have cash flow problems. 4

5 Average Collection Period = 365 Receivables Turnover Asset Utilization Period - suggests how effectively the money invested in plant and equipment is being utilized by showing how many dollars in sales are being generated by dollars in assets. Asset Utilization = Total Total Assets Profitability - these ratios are crucial because they indicated how profitably and efficiently your business is operating. Gross Profit Margin - this ratio indicates your business s ability to meet direct costs and operate profitably. Gross Profits = Net (minus Returned Goods, Discounts, Price Reductions) minus Cost of Goods sold. Gross Profit Margin = Gross Profits Selling, General & Administrative (S,G & A) Expenses to - shows the percentage of dollars absorbed by overhead (selling, general, and administrative expenses). These expenses are necessary to understand the degree to which they require support from sales. S, G, & A to = Selling, General & Administrative Expenses Return on - measures the profitability of the business. This ratio illustrates the percentage of profits remaining after direct expenses, overhead, unusual items, and taxes. Return on = Net Profit After Taxes SUMMARY Applying for a bank loan for your business can be a stressful experience. Knowing ahead what bankers look for can ease the process: 1) be prepared, 2) present your loan request in a professional manner, and 3) look for ways to further add to your credibility. Keep in mind: Never ask for more money than you need; however, make sure you never underestimate your needs! Meet the banker with an organized, thorough business plan (contact the Small Business Development Center (SBDC) at (715) for an example of a business plan guide with a complete set of financial statements! Apply the ratios mentioned previously to your business financial figures. Remember that knowledge is power, and the more you know about your business, the better able you will be to answer any questions or objections the banker may have. Pay special attention to the five C s the banker looks at when evaluating a potential loan. Interview your lender! Remember you are their customer and they are always looking for good loans to write! Negotiate the interest rate or number of services the bank is offering your existing/potential small business. If you are interested in other financing sources, refer to the handout Alternative Financing Sources for Your Small Business. To obtain a copy, call the Small Business Development Center (SBDC) at or s:\handouts\finan comm banks.doc 5