People with steady jobs and good credit histories easily qualify for personal loans. Their wages provide the capacity to make payments. The same loan amounts borrowed for a new business are harder to obtain.
During my time with Community Futures, I reviewed hundreds of loan requests from people either starting or expanding their businesses. Like a game, understanding the rules increases your odds of arranging a deal with a lender.
Types of Business Loans
The type of loan needed depends on what is being financed. Term loans and commercial mortgages are typically used to finance long-lived assets such as delivery vehicles, equipment, or land. Term loans are repaid over several years with interest. Credit lines or operating loans are intended for temporary financing of inventory and accounts receivable during peak seasons and for large projects.
How Banks Review Business Loan Applications
If you view your loan request from the banker’s perspective, you can better meet their information needs. Rookie lenders are often taught the “4 C’s of credit”. What the four C’s stand for somewhat varies but typically the C’s are: 1) character, 2) capacity, 3) collateral, 4) conditions or capital. This article focuses on the first two, as character and capacity overlap, and will largely determine if a loan is repaid.
1. Character of the Applicant
Character is the least intangible “C” and is the hardest to judge. The applicant’s past credit records, for both the business and its owners, will be reviewed. Does the applicant have a track record of paying on time? Nowadays, banks use credit scores to assess personal creditworthiness.
Character refers to more than an individual’s credit score. Issues such as personal integrity, commitment to the business, and mental agility are assessed. When you start a business, the people who will pay hard earned cash to buy your products or services are often different from what you expect. Your ability to quickly read the market and adapt to surprises can make a difference between success and failure.
Our society, which served small cities and towns, carefully selected its directors to include people who were well connected to their communities. On occasion, the society made “character loans” based on their recommendations. These people typically repaid their loans in full.
2. Capacity to Make Payments
The ability of a business to generate the cash needed to repay a loan is its capacity. For existing businesses, capacity can be determined from your past financial statements and forecasts. Your cash budget is a key document.
For new ventures, it is harder to demonstrate capacity. Our society asked our clients after a year how they performed relative to expectations. A large majority said their sales were less and their expenses were higher than budgeted.
For new ventures, capacity is based on both an assessment of the people running the business and a careful review of the numbers. Start up costs are easier to forecast than operating expenses. Equipment is easier to forecast and finance than working capital (e.g. accounts receivable and inventory less accounts payable). Sources of information include existing business owners, industry magazines and reports, how to books, suppliers, landlords, etc. Expect the lender to ask how you estimated your revenues and specific expenses.
The other C’s of credit are also important. Collateral provides the backup plan for the lender if the business doesn’t succeed. The investment in the business by its owners must be reasonable relative to the amount requested. Current market conditions are also important.
Like most things in life, preparation is key to a successful loan request.