With the excitement and opportunities of owning a business comes the arduous task of funding it. Avenues for financing your venture can include garnering investors, using business or even personal credit cards and taking out small business loans. With some thinking, planning and good preparation of your credit and finances, the application for a small business loan does not have to be daunting nor does approval have to be beyond reach.
Why Do You Need a Loan?
Before you apply, ask yourself why you need a loan. The lender will. Responding with “for your business” or “to grow your business” does not suffice with most lenders and should not suffice with you. Ambiguity and generalities highlight your lack of a prepared, well-thought business plan or strategy.
Think about the kind of business you have or intend on having. Are you a manufacturer? Are you in the restaurant business? Do you run a small clothing shop or a service station? Is your establishment a franchise? Are you rendering professional services?
The answers determine the type and quantity of equipment, materials or other assets you need. Manufacturers and delivery companies need considerable funding for machines or fleets of light-duty or even larger trucks and vans. If you own or run a restaurant, you need stoves, commercial-grade refrigerators, sinks, exhaust fans and other kitchen fixtures. For accountants and lawyers, computers and software feature prominently in assets.
As part of your application “due diligence,” obtain price or cost estimates of these or other assets you’ll need or of the upgrades. Prospective franchise owners often receive a list of anticipated costs and funds needed at the time of applying for a franchise.
Personal Credit Scores
Once you have an amount to borrow in mind, you move to preparing yourself as a credit-worthy applicant. Your personal credit history matters in applying for a business loan, though it may not seem apparent at first. However, if you’re assuming personal responsibility for business debts, you need to demonstrate your ability to pay them. You stand personally liable for business debts when you operate as a sole proprietor or a general partner.
Even the formation of a corporation or limited liability company doesn’t necessarily eliminate the prospect of personal liability exposure. In particular, new businesses or those with at best a brief or spotty record may not appear by themselves to be good credit risks. As a consequence, lenders may call upon the owners of these “limited liability” enterprises to personally guarantee the loan as a condition of approval.
Your credit score serves is the main barometer of your creditworthiness. While there are many scoring services, the most prominent is FICO, which stands for Fair Isaac Corporation. FICO assigns scores between 350 and 800 based upon your payment history, your outstanding balances, credit utilization, the age of accounts and inquiries made by creditors. VantageScore and CreditKarma also grade your handling of credit with similar criteria.
Obviously, having judgments, bankruptcies and a history of late payments can damage your credit score. Here are a few other potential pitfalls:
*Closing a zero-balance credit card. It seems counterintuitive to keep a card when you owe nothing on it. However, closing such a card affects your credit utilization rate. This figure is the total of your outstanding balances divided by your credit limits. As a rule of thumb, going north of 30 percent on the rate may show that you excessively depend on credit and may experience cash flow problems. Additionally, a credit card with a zero balance may be one you have held for a while. By closing it, you make it appear as if you have a shorter credit history than is actually the case.
*Chasing Introductory Offers. Jumping at teaser rates such as “zero percent for 12 months” may erode your credit score. Each application by you for credit generates an inquiry to the credit reporting agencies from the would-be creditor. Frequent requests for credit may hint that you may overly burden yourself in debt, especially to meet monthly expenses or pay other bills.
*Erroneous Information. Faulty credit information generates faulty credit scores. You can prevent this with a diligent examination of your credit reports. Each of the three major bureaus — Equifax, Experian and TransUnion–provides you one free credit report each year. AnnualCreditReport.com is your portal to the reports. If you see an error, such as an account you didn’t open or payments that were not properly applied, you can dispute it and seek a correction. Credit monitoring services supply regular updates and alerts that might catch identity thieves.
*Always Paying “100 Percent Down”: Demonstrating your ability to handle credit lies at the heart of a credit history. You can’t build one if all of your purchases involve cash. Consider a car loan, mortgage or personal loan, which often involves a monthly payment over multiple months or even years.
Business Credit Scores
Just as you, your business has its own credit score. Equifax, Experian and PAYDEX grade businesses on their handling of credit. The scores reach a maximum of 100.
With Paydex, a service of Dun & Bradstreet, your score depends exclusively on your payment history and indicates the average number of late days. For example, a PAYDEX score of 76 tells lenders that you’re on average eight days late. When you score south of 80 on Paydex, lenders become concerned that you’re a risk for default and otherwise potentially unreliable when it comes to business loans. On-time or even early payments can place you above 80.
Equifax and Experian rely on information from collection agencies, lawsuits, bankruptcies, judgments and other public filings and records regarding your business. To achieve “Excellent” status, you need to score between 75 and 100. Below 75, you become a risky company to some degree. Those businesses scoring below 10 on their business credit scores through Equifax and Experian are deemed “high risk.”
The advice to pay on time applies to business loans as well as personal or consumer ones.
Financial Condition of the Business
A bank wants your income information for a home or car loan. Business lenders like us who do cash flow financing likewise want to know what profits your enterprise generates. Without sufficient income, you can’t repay the loan and your other obligations. To that end, your income (profit/loss) statement proves essential for a business lender to evaluate your ability to repay and for you to examine how to improve your operations. The income statement reveals:
*Revenues. What are your sales figures? Which products or services generate the most customers and sales? What should you drop from your inventory, menu or other selections for customers?
*Gross Profit. Here you subtract from sales the cost of making those sales, otherwise known as “cost of goods sold.” In general terms, these costs consist of the raw materials, supplies, equipment and labor that directly contributes to them. If your gross profit runs too low, consider whether you’re pricing too low or if your product or service does not appeal to customers. Gross profit also can tell you if you need to find less-costly suppliers, trim labor costs or improve the efficiency of equipment.
*Net Profit. After calculating gross profit, you take out overhead and other operating expenses. Items such as marketing and advertising, utilities, management staff, interest payments and taxes generally apply to the enterprise or establishment as a whole rather than to a specific product or service. Net profit grades the overall efficiency of the business.
What You Need When You Apply
Completing the forms for the application generally involve little, if any, complications or complexities. However, you will to gather and present financial information to support your requests. These items include:
*Tax forms. Produce business tax returns for the last one to two years.
*Financial statements. While your income statements stand as most important, it can help you to have balance sheets and cash flow statements. With the assets, liabilities and equity shown on a balance sheet, business loan underwriters can see whether the business is solvent or the risk of insolvency. Cash flow statements, though optional, help you and the lender see what cash is generated from your business operations and whether you’re relying too heavily on loans or investors to keep the enterprise afloat.
*Accounts Receivable. These reflect sales and amounts that are owed to the business. If this item remains the same, but you’re not generating more sales, it may indicate you have non-paying customers. You ultimately want and need cash for the business to survive and thrive.
*Accounts Payable. The measure here is of what you owe.
With any loan, business or otherwise, there is a cost. The interest rate, as you traditionally think of it, represents the price in terms of a percentage of what you borrow. As such, a five percent rate on a $100,000 loan appears to be a better deal than a $100,000 loan at eight percent.
However, factoring the fees and charges for the loan may afford a more accurate portrayal of the cost of the loan. These fees may include appraisal costs of assets used as collateral, document preparation fees, loan origination fees and title searches on any property used as collateral. When you add these fees to the interest, you get an annual percentage rate (APR). Be sure you examine these numbers in deciding on your business loan.