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3 Things to Know to Get a Business Loan
For small businesses, lenders can tell from a glance at your loan application if it is worth considering. All they want to know is the answer to these three simple questions:
- Can you pay?
- Will you pay?
- What happens if you don’t?
The lender’s decision will involve a careful look at the details, which is done to confirm and document their initial assessment.
The numbers used to evaluate the borrower are simple ratios that you can calculate yourself using your Income Statement and Balance Sheet. The lender will produce ratios based on key income statement and balance sheet numbers. You can calculate the ratios yourself, and understand what they say about you.
Can you pay?
What is left over after the bills are paid is called Cash Coverage Ratio. To calculate add together net income and non-cash expenses (depreciation and amortization). This is roughly your total net cash flow. Now divide this number by the total annual new loan payments this equals the Cash Coverage Ratio.
The lender will want a ratio of 1.2 to 1.5 or higher. If your payments on the new loan total $30,000 a year and your net cash flow is $ 45,000, your Cash Coverage Ratio is 1.5.
Will you pay?
How have you handled debt in the past – the Business Credit Score – is probably the best indication of how you’ll handle debt in the future. Your Debt-to-Equity Ratio, tells an important story too. It tells a lender how much you have at risk, which is a good indication of how much the lender would have at risk. If you are already using a lot of non-investor money, the lender will think twice.
Your simple ratio of Debt-to-Equity is calculated by dividing total equity by total liabilities. These numbers are found on the balance sheet. The lender wants to see a ratio that is no more than three or four time’s equity. So if you have $50,000 in equity, you should have no more than $150,000 to $200,000 of debt.
The ratio can be improved if there is “friendly debt” on your balance sheet. If current lenders are willing to “subordinate” there loan (allow you to pay back the lender before you pay them), the lender may actually treat the debt as equity.
What if you don’t pay?
But what if the worst happens: your business situation changes and you can’t pay? The lender will want to know what they can sell. The tangible assets such as buildings, machinery and vehicles are usually what they want.
You can use whatever you’re buying as collateral, but it will not be enough. The reason it is not enough is because resale value is always lower than purchase price.
Various kinds of collateral have various “collateral valuations,” and the lender will use a range as a guide.
- Accounts Receivable: 20 – 80 percent
- Inventory: 10 – 80 percent
- Furniture and Equipment: 10 – 80 percent
- Real Estate : 50 – 90 percent
- Cash/Investments: 50-90 percent
The collateral’s quality and marketability impact if valued at the high or low end of the ranges. In the case of accounts receivable, the quality of your customers, their credit ratings and their payment histories will determine the collateral value. With inventory, it depends on what it is, where it is, how old it is and whether anyone wants it.
Anything you can do to prove the salability of your assets will help the collateral case. Be sure the lender knows what you know about the value of your collateral – they will change the valuation if you can convince them it is worth more than they estimated.
Keep in mind that the ratio expectations are not hard settings. If your debt-to-equity ratio is more than 3 or 4, for example, it may be offset by a strong cash flow.
To the lender the ratios are like the cover of a book. If they do not read well, they may not bother to look any further. Calculate the ratios yourself, follow the tips and you may be able to sell them a lending scenario the lender might not have considered otherwise.
If you want help understanding your ratios and how a lender views your business, or need assistance through a process to obtain bank financing, contact Fahrenheit Finance at 804-955-4440.