Over the years, I have worked with countless small business owners as a business banker and CPA, and found that most owners share one thing in common: when applying for a bank loan, very few have an understanding of what a bank loan officer is actually looking for.
At some point, however, most small business owners will find themselves at a bank applying for a business loan, whether it is to purchase a building, buy equipment, or obtain necessary working capital. Here are some secrets on how to successfully go through the process.
Understanding the Business Loan Application Process
As part of the loan application process, you will need to provide historical financial information, which will help the bank determine how much you can qualify to borrow and if you will be able to repay the loan in the future. While every bank's lending process is different, you typically will need to provide:
- Reason for the loan request
- Three years of business tax returns
- Three years of personal tax returns for each beneficial owner
- Personal financial statement
- Year-to-date income statement and balance sheet
Bankers will also assess:
What your business does. In the commercial lending world, banks are more willing to lend to certain industries and less willing to lend to others. For example, if a printing press company came to a bank seeking a loan, while it may not be a firm disqualifier, the industry itself is a consideration; a bank is less inclined to lend to a business that's part of a declining industry.
A loan officer must also adhere to its internal policy, approved by the bank’s board of directors, detailing types of industries the bank is prohibited from lending to. Common examples of industries that may be prohibited from receiving loans include political campaigns, firearm dealers, or businesses that sell illegal products. The most notable is the cannabis industry; cannabis has been legalized in some U.S. states, but is still federally prohibited. Banks are federally regulated by the FDIC and Office of Comptroller of the Currency (OCC), and lenders undergo routine audits to ensure a bank's policy is adhered to.
Additionally, if you are applying for a federally backed business loan, like with the Small Business Administration (SBA), there is an additional list of prohibited industries, including government organizations, nonprofits, and real estate investment companies.
How long your business has been in operation. If your business has been around for two years or longer, you are in good shape. However, if your business has been in operation for less than two years, it will be more difficult to obtain financing. If you're a new business, a better option is to apply for a government-backed business loan, such as a loan from the SBA. Depending on where you're located, there may be state programs available as well.
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Bank Loans and the 5 C’s of Credit
One way to understand how a bank will approach your loan application is to take a look at the credit underwriting process. The 5 C’s of credit determines an applicant's creditworthiness. The 5 C's are:
1. Character
In my opinion, character, which includes the owner's background and the experience they bring to the table, is the most important part of a business loan request. And being upfront and honest can go a long way in your loan application process. Bring up any financial trouble that the business may have had in the last three years and how you have fixed the problem; share reasons why you may have a low personal credit score; and disclose any historical bankruptcies, and any current or recent litigations. The bank will most likely learn about these situations on its own, but by providing details at the beginning of the loan process, you will build trust with the lender over the long term.
If you are an owner, you may be surprised to learn that you most likely will have to sign on the business loan as a personal guarantor. This is a contingency and a promise to pay the bank in case the business cannot. As part of this, you will likely have to fill out a personal financial statement, which gives the bank authority to look at your credit score and assess any derogatory remarks (information on your credit report that may show adverse performance). These may include late payments of 30 days or more on an existing loan, existing amounts that are past due, unpaid bills reported to collections, and judgments or liens that are a matter of public record.
Having a credit score that's over 700 is best in the eyes of a banker. Also, try to keep your credit card balances at 30% or less of the credit limit. High utilization ratios may show you are over-leveraged personally.
2. Capacity
The bank will want to see that you will be able to repay the loan from the business's income. As mentioned earlier, you will want to provide as much financial information as you can to your banker so they can assess your company's cash flow.
Note: your banker may also take into account any unfinanced capital expenditures that were made during a given year and subtract that from available cash flow. Your banker may also decide to take into account changes in loans from/to related parties, as well as cash distributions.
3. Collateral
The next thing that the bank will look at is the collateral of the loan. These are the assets a lender accepts to secure the loan. While the borrower is the business, if it does not have sufficient collateral, the bank may then ask you to provide personal assets to secure the loan, such as a junior mortgage on your home. Smaller microloans have less stringent requirements for collateral.
In the unfortunate case of a liquidation scenario, the lender would repossess the collateral of the loan to then sell. The equity injection provides a cushion of value in that the bank could sell more quickly at a less-than-market value and still fully recoup the remaining balance of the loan.
4. Capital
A less-known aspect of the lending process is that some banks require an equity capital contribution. For example, if you are purchasing a business property, the bank may ask for a 20% down payment. Or, if you're planning to purchase equipment, the bank may ask you to finance a certain percentage as well.
5. Conditions
The last C of credit is conditions. Conditions are the defined requirements that need to be fulfilled by the borrower, the lender, or a third party prior to or after closing. For instance, a business loan structure may list the borrower of the loan as the business and any beneficial owner as a guarantor. If you own other businesses, the bank may ask those entities to be corporate guarantors as well.
Additionally, be mindful of any financial covenants, or requirements, that the business has to adhere to as long as the loan is outstanding. For instance, affirmative covenants include submitting annual business tax returns to the bank, maintaining sufficient cash flow from operations to support the loan, or paying a line of credit down to a zero balance for 30 consecutive days each year. A negative covenant would include requiring the business not to have a deficit net worth reported on its balance sheet.
If your bank requires a covenant, be sure to talk with your accountant to make sure you stay in compliance.
It Helps to Know What Bankers Look for When Applying for a Business Loan
Banks will look at your loan application on a holistic basis in that they want to peel back all the layers of the onion, so to speak.
By looking at the business itself, the business's ability to repay the loan through income from operations, any collateral coverage, and the support from owners with their guaranty, a bank can assess all the risks associated with an application.
By preemptively structuring your business and personal finances, you will increase your chances of getting your financing approved.
FAQs on How to Get a Business Loan From a Bank
What does the bank require before you can get a business loan?
A bank will want a business to report sufficient cash flow from its profits to pay for the loan payments, collateral coverage, and support from its beneficial owners (likely to also be personal guarantors). A startup should provide a solid business plan containing a strategic overview of the operation, a market and competitive analysis, and two years of financial projections with assumptions.
What factors do you need to consider before taking out a business loan?
Seven factors you need to consider before taking out a business loan include:
- What is the reason for the loan request and how much financing will you need?
- What type of business loan will you need?
- Are you willing to pledge collateral for the loan?
- Will taking out a loan help grow your net income over the long term?
- Are you willing to provide a personal guarantee?
- What are the economic conditions of your industry?
- What documents will you need when you apply?
What are the steps to getting a business loan?
The 7 steps to getting a business loan are:
- Decide what type of loan you need.
- Compare lenders in your area that provide the type of financing you need.
- Submit the loan application with a lender who is a good fit.
- Review and sign a term sheet that details the structure of the loan before underwriting.
- Wait for the bank to perform a complete analysis for a final approval decision.
- Review the fine print on all loan documents prior to closing.
- Sign loan documents and obtain funding.
About the Author
Post by: Ryan Walsh
Ryan Walsh is a certified public accountant in the state of Massachusetts and also has years of experience as a business banker, specializing in small and medium sized businesses. He has worked with hundreds of small business customers over the years across a multitude of industries. Ryan also operates an accounting blog to help share financial information.
Website: www.thataccountingguide.com
