June 29, 2018
Guest Blog by Craig Ehrmantraut, Cornerstone Bank
As a small business, one item to consider is financing. Before you look into meeting with a bank, make sure you understand what they're looking for. We talked to a local banker who highlighted three broad categories banks consider: business cash flow, personal financial strength, and collateral value.
Business Cash Flow
The first and most important item, business cash flow, analyzes if the business will generate enough cash flow to be able to repay the loan. If you have any historical financial information, this will be the most important information to bring. You should also work with your accountant to prepare projections. How will the loan you are applying for impact your revenue and expenses?
Personal Financial Strength
For this you will need your most recent three years of tax returns as well as a list of assets and liabilities, which we call a personal financial statement or statement of net worth. Your accountant should be able to provide a personal financial statement template and assist you in filling it out.
In addition, the bank will pull a credit report on you personally. This is done because the vast majority of commercial loans require a personal guarantee. Most banks require anyone owning 20 percent or more of the company to provide a personal guarantee. This means if the business cannot make the loan payments, you are personally responsible to do so. Therefore, the bank will look to see if you have other sources of income, or other assets you could leverage or sell to pay them back. Your personal credit report also shows the bank how well you have handled your personal finances, which is a good indicator of how you will handle your business finances.
Lastly, the bank will look at the value of the collateral that will be pledged to the loan. What does that mean? Well, if you default on your loan, the bank will now own the collateral you put up against it. So they have to make sure of a few things:
Therefore, collateral that is readily marketable, such as real estate or vehicles, is easy for the bank to sell, and will therefore require less money down. For these types of business loans, the average down payment is 20 to 25 percent. However, if you are looking to open a business with specialized equipment or inventory, like a brewery, the bank would not be excited to try to sell fermentation tanks and boilers if you defaulted on the loan, and would therefore require additional money down. For loans to purchase this type of equipment you may be looking at up to 50 percent down.
The other item collateral impacts is the number of years the bank will allow you to pay the loan back. There is no magic number for each kind of collateral, but the best advice I can give is look at the usable life of the asset. This is another area where meeting with an accountant prior to the bank meeting is important. The number of years you can depreciate that collateral over is tied to the useful life. Banks normally like to have their loan paid back in a period of time less than the useful life of the asset. Therefore, if the useful life (or depreciation period) is seven years, the bank would like to have their loan paid back in five.
With all of this being said, banks realize all businesses and industries are different. If you have a loan request that does not fit the normal financing guidelines, there are other ways to mitigate the bank’s risk. Check out the programs the Small Business Administration (SBA) has available. These programs exist to promote economic growth and assist small businesses. The most common SBA programs require a bank to originate the loan, and if it goes bad, the SBA will step in and reimburse the bank for a percentage of the bank’s loss. The reimbursement rate can be as high as 75 percent. These programs can result in a loan getting approved when it might otherwise be denied, or it can allow the bank to be more flexible with their lending terms.
Let’s go back to the previous example. Say you have collateral where the useful life is seven years. The bank normally requires a five-year payback. However, with an SBA guarantee, the bank may be willing to push the payback period out to seven years, reducing your monthly payment substantially. Do not be afraid to ask your banker about these programs.
So what’s the moral of the story? Be prepared to go in and talk to the bank. Know your company’s financial standing as well as your projections for the future. Banks want to be a partner in your journey, but they also want to ensure you’re ready and adequately prepared for the journey ahead.