As the U.S. economy moves from recession into recovery, small businesses, which employ half of all private-sector employees, have been identified as a crucial engine for growth. The thought is that if small business owners can obtain loans, they will be able to produce more goods and services and hire more people. Banks are working closely with small business owners to evaluate their credit needs. An important first step is to help them understand how to put their best foot forward when applying for a loan.
Generally, banks evaluate the creditworthiness of a loan request on five criteria, called the five Cs of credit.
- Character. This is the first threshold potential borrowers must meet to be considered for a loan. Is the business owner a person of integrity? Does he or she have a history of meeting their obligations? In short, can the borrower be trusted?
- Capacity. Next, banks take a look at financial statements and business cash flow to determine if the borrower has the ability to repay a loan under reasonable assumptions. Cash flow will also determine the amount of credit that will be extended. The loan amount should not be so high that nearly all of the company’s cash flow must be used to service the debt. It’s better—and really required—that businesses have a cushion so they can weather some variance in cash flow without falling behind on payments.
- Capital. Capital in this context means equity or the net worth of the business. In order to qualify for a loan, a business must have assets that exceed liabilities. The more assets a business has compared to liabilities, the more well capitalized the business is considered to be. A well-capitalized business has better prospects for sustainability and growth, and when a loan is made, both the bank and the business owner have real dollars invested in the business—“skin in the game,” so to speak.
- Collateral. When banks underwrite a loan, they expect to be paid back out of the cash flow generated by the business. However, if things do not go as planned, collateral is the secondary source of repayment. An important point to keep in mind is that not all collateral is created equal. Assets such as property and buildings that can typically be marketed and resold to a broad range of potential buyers are considered more valuable collateral than specialty inventory and equipment, for example, which may have a limited market and low resale value.
- Conditions. Conditions are outside forces that affect your business, such as current or pending government regulations, economic factors and competition in your particular industry. It is important for banks to see that you have considered these factors in your business planning process. Banks will also take a look at these external conditions when evaluating a loan request.
Occasionally businesses approach banks for a loan when what they really need is something else—to optimize cash flow, restructure existing debt or get an infusion of equity. The first two we can help with, but the latter is something banks can’t provide. Trying to finance equity into your business is a bit like finding that you are having trouble paying your bills and trying to open a credit card to cover expenses. It’s financial advice that most of us would never give someone else.
While many businesses are holding off on major investments and paying down debt, now may be the perfect time to purchase property or equipment while prices are low, provided this strategy is appropriate for your company. Take a look at where your business is. Better yet, sit down with your partners—your banker, attorney and accountant—and assess the risks and potential returns. Whether you decide on opportunistic expansion or choose to stay on the sidelines until the economy improves, by taking time now to revisit your business plan, you will likely emerge from this difficult time stronger and better positioned to grow. iBi
