Guidelines used by Lenders
By David Conley, Score Accredited Counselor, Score NE Mass Chapter
Business loans fall into two general categories—term loans and lines of credit.
- Term loans. These are used to finance such items as machinery, equipment, and vehicles and are almost always secured by the purchases by placing a Uniform Commercial Code (UCC) lien on the item(s). A loan must be repaid over the useful life of the item(s) financed. Expect repayment terms of two to seven years. Because the borrowed amount must be repaid over this relatively short time, the size of the monthly term loan payment is a major expense for a small business and the impact of the required cash flow needs careful planning.
- Lines of credit (LOC). These are most often used to finance production costs usually related to seasonal business cycles. Borrowings most often cover labor and inventory costs not paid for up front by customers. The LOC monthly payment is for interest only on the outstanding balance of the line. Frequently there is a facility fee charged by the lending institution to set up and maintain the arrangement. These loans as a rule don’t have a predetermined monthly principle payment and are usually payable in full by the end of the loan contract period. A LOC most often is arranged for one year though may be renewed over a five year period. However at the end of the contract period the LOC may be extended for an additional term if the business is performing well. Most lenders require these arrangements to be paid down during the annual contract period to a certain level (often 20%-25% of the line) for from 30 to 60 days. This in to ensure that the credit is being used prudently and that the business is generating enough cash flow to manage the debt. Inventory and receivables are pledged as collateral.
Businesses often have both types of loans.
Credit is granted to the two segments of the business borrowing market in different ways:
- LARGE BUSINESSES: only well-established, profitable businesses with substantial cash flow and assets can use their financial strength, or credit, to obtain loans.
- SMALL BUSINESSES: most small business loans require the owners to have good credit and to give their personal commitment or guarantee [often to secure the debt(s) with personal assets] to ensure repayment of the borrowings. Personal credit is relied upon by lenders because the business does not have a proven, reliable capacity to repay the debt. As well, most small businesses are too small to have a well-developed management team to ensure continuity or continued business operation should the owner decease. This necessitates dependence upon owners’ personal assets to repay loans.
Credit structure is guided using these two standards:
- Down Payment—most lenders require the principals to contribute capital of 10% to 20% toward an asset purchase.
- Interest Rates—Interest rates for business loans are based on credit and collateral. Rates are usually tied to the prime rate. The strongest companies get the lowest rates.
Criteria for loan evaluation. The four “C’s” or credit are a traditional way to approach “bankability”—the ability to qualify for a loan.
- Credit—Good personal credit of all principals as evidenced by Fair Isaac Corporation’s (FICO) numeric rating aggregated from credit bureau scores. Personal guarantees of the principals are almost always required for privately owned businesses. Personal debt levels and prior debt repayment are carefully evaluated.
- Collateral—This may be in the form of capital (business owned cash savings, marketable securities), or tangible business assets such as equipment or vehicles. Often borrowers are required to pledge the equity in their homes or other personal assets.
- Cash Flow—The income generated by the business as evidenced by historic financial statements, budgets and business plans.
- Character—This is generally an analysis of the borrower’s relevant business experience. Lenders usually require experience in the same or a closely related business. A borrower starting a business with no relevant experience will be required to provide considerably more collateral and will probably need a higher FICO credit score.
The four “C’s” are general guidelines for determining a borrower’s ability to obtain financing. Each lender evaluates loans differently. Borrowers should always start where they have existing banking relationships. Be aware that being turned down for credit at one lending institution can be seen by other lenders as a negative credit event.
This means prior thoughtful preparation before going to a lender is vitally important if one wants a successful loan funding outcome. SCORE is prepared to mentor you in this process. We have a passion for helping business owners achieve success. This is a fundamental area where we have lots of experience. Come sit with us and see how we can help you.