BY MARK ABELL
For small business owners in need of a loan, getting an application approved can seem as mystifying as the illusions performed in a Las Vegas magic show. But the process gets a lot easier with the right preparation and an understanding of the importance of cash flow.
A survey by the 12 regional Federal Reserve banks cited “accessing necessary credit” as the No. 1 challenge facing small businesses in 2016. That was especially true for outfits with less than $1 million in revenues; while 72% of larger companies were able to secure financing, only 45% of smaller firms could get the nod from a lender.
Getting a small business loan isn’t magic, but it does require meticulous preparation and an understanding of how bankers operate. Underwriting decisions are based on the 5 C’s of credit — capital, collateral, conditions, creditworthiness, and cash flow — and borrowers must show strength in each.
Here are five ways small business owners can turn a “no” into a “yes”:
1. Apply for the right loan at the right bank. Loan applications are often declined because borrowers seek the wrong type of loan, or engage with the wrong institution. For example, a company that needs money to fund a new line of business would be turned down for a line of credit because a term loan would be more appropriate. Similarly, applications are often declined because the bank does not lend to certain industries, such as loans for hotels. When seeking a bank, make sure it actually lends to your industry. If they don’t, find a lender that does. Applying for the right type of loan from the right type of bank is the first step to getting approved.
2. Show your cash flow. Most loans are turned down because bank underwriters can’t find sufficient cash flow to support loan repayments. Documentation starts with three years of corporate and personal tax returns and three years of corporate financial statements; current year-to-date financials with prior year comparisons; a debt schedule, including real estate and equipment leases; accounts receivable and payable reports; and an inventory report. With this information in hand, the underwriter will determine how your cash flow compares to the anticipated debt payments.
Cash flow is typically calculated as net income plus interest expense, depreciation, amortization, and non-recurring expenses — such as rent if you are buying real estate — less distributions. But understanding your business cash flow may not end there. Providing additional information can be critical to getting loan approval. Start by creating a narrative that helps underwriters understand anything that should be taken into account to get the loan. Think back: Were there one-time expenses or unusual circumstances in any of the last three years that hurt performance? Think ahead: Are there changes on the horizon that will boost revenues or mitigate expenses?
Preparing a business plan with detailed projections is crucial in these cases — local Small Business Development Centers and SCORE Association chapters can help. The business plan should document any contracts that will support the loan and provide a detailed explanation of how the funds will be used. A good banker will ask the right questions to help you turn your request into an approvable deal, but taking control will help you help yourself.
3. Bolster your personal credit. For small business owners, personal credit scores have a major impact on corporate credit worthiness, so improving scores in advance of seeking a loan is vital. Most people understand that paying bills late will hurt their credit score, but credit bureau models have changed in recent years. Today, high levels of credit card utilization lowers credit scores dramatically — especially if it exceeds 50% of the available revolving credit. And, since many small business owners use their personal credit card for business travel and routine expenses to take advantage of points and other benefits, utilization is up.
But here’s a secret for those that pay off their credit cards each month: Making credit card payments four days in advance of due dates will result in dramatically lower utilization and can significantly improve credit scores. I know of a recent loan applicant who improved his score by more than 30 points in one month by using this trick.
4. Calculate your collateral. Underwriters discount the value of collateral based on the bank’s past experience liquidating loans. Underwriters typically use about 50% of the value of raw materials and finished goods inventory, 70-80% of accounts receivable, and 50%-80% of fixed assets such as equipment, machinery, furniture and office equipment. Companies turned down for insufficient collateral can offer to add collateral, if possible, or they can seek a U.S. Small Business Administration-backed loan. SBA loans are more flexible on collateral when cash flow is sufficient. Such loans also can have longer terms — up to 10 years versus five years with conventional loans — and this can have the added benefit of improving cash flow calculations.
5. Improve your equity. Small businesses can appear to have too little equity value or too much leverage (a measure of the total liabilities compared to the total equity retained in the business), especially when owners withdraw most or all of the excess cash flow each year. However, modest changes to your application and a little planning can dramatically change that picture. Can the business owner contribute a down payment on the project being financed to bring these equity-to-debt ratios more in line? Can the owner take a lower salary or distributions in order to maintain more cash in the business? Alternatively, can the owner show underwriters personal savings accounts funded by the business that effectively act as equity? As a rule of thumb, banks don’t like more than $3 or $4 of debt to every dollar of equity.
Some businesses — especially those in cyclical and seasonal industries — can still struggle to secure financing based on industry and market conditions. In many cases, SBA loans can overcome conventional lending challenges, whether that’s approving a loan with a low down payment, or companies that have high leverage or insufficient collateral. In the end, undertaking the right preparation in advance, whether it’s for an SBA-backed or conventional loan, takes the sleight of hand out of getting loans approved. When a business can show cash flow available to support the requested debt, the bank can usually find a way to say “yes.”