     |
The Secrets of Borrowing Money
Leadership-Tools Original Article Borrowing money is one of the most common sources of funding for a small business, but obtaining a loan isn't always easy. This discussion outlines some of the key factors a bank uses to analyze a potential applicant before making a decision on a loan request. The secrets of borrowing money are no longer secret! Also included is a self-assessment checklist at the end of this section for you to complete. KEY POINTS TO CONSIDER WHEN BORROWING MONEY Let's begin by exploring some of the key points your banker will review: 1. Ability to Repay/Capacity In order to analyze the cash flow of the business, the lender will review the business's past financial statements. Generally, banks feel most comfortable dealing with a business that has been in existence for a number of years because they have a financial track record. If the business has consistently made a profit and that profit can cover the payment of additional debt, then it is likely that the loan will be approved. If however, the business has been operating marginally and now has a new opportunity to grow or if that business is a start-up, then it is necessary to prepare a thorough loan package with detailed explanation addressing how the business will be able to repay the loan. When borrowing money, each step of the process you know BEFORE you begin will increase your chancing of getting the loan. 2. Credit History First get your personal credit report. You can obtain a report by calling or going online to TransUnion, Equifax, TRW or another credit bureau. It is important that you initiate this step well in advance of borrowing money, or seeking a loan. Personal credit reports may contain errors or be out of date. In many cases, people find that they paid off a bill but that it has not been recorded on their credit report. It can take 3 to 4 weeks for this error to be corrected -- and it is up to you to see that this happens. You want to make sure that when the bank pulls your credit report that all the errors have been corrected and your history is up to date. Once you obtain your credit report, how do you know what it says? Many people receive their credit reports yet have no idea what the strange numbers signify. The following should help in interpreting and checking your personal credit report. First, check your name, social security number and address at the top of the page. Make sure these are correct. There are people who have found that they have credit information from another person because of mistakes in their identification information. On the rest of your credit report you will see a list of all the credit you have obtained in the past when you’ve borrowed money - credit cards, mortgages, student loans, etc. Each credit account will be listed individually with information on the payment history. Any credit account where you have had a problem in paying will be listed towards the top of the list. These are the credits that may negatively affect your ability to borrow money. If you have been late by a month on an occasional payment, this probably will not adversely affect your credit. However, if you are continuously late in paying your bills, have an account that was never paid and charged off, have a judgment against you, or have declared bankruptcy in the last 7 years, it is likely that you will have difficulty in obtaining a loan. In some cases, a person has had a period of bad credit based on a divorce, medical crisis, or some other significant event. If you can show that your credit was good before and after this event and that you have tried to pay back those debts incurred in the period of bad credit, you should be able to obtain a loan. It is best if you write an explanation of your credit problems and how you have rectified them and attach this to your credit report in your loan package when borrowing money. Each credit bureau has a slightly different way of presenting your credit information. You can get specific information on "how to read the report" from the appropriate credit bureau company, but here's a few tips to get you started: TRW In the last few years TRW has prepared credit reports with words and not numbers. When borrowing money, this makes reading a credit report much easier. Good credits should read "Never Late", "Paid as Agreed". Poor credits will read as "Charged Off", "Past Due", etc. TransUnion On the right side of the page on the credit report are number and letter combinations. "I" means installment credit. "R" means revolving credit. The key information is in the numbers. A "1" means perfect credit since you have always paid your bills on time. "2" or "3" means you have been 2 to 3 months late in paying your bills. Too many of theses will hurt your chances in obtaining credit. A "9" means delinquency in paying your bills and a charge off. This could make it difficult in obtaining a loan. When borrowing money, if you need assistance in interpreting or evaluating your credit report you can ask your accountant or a friendly banker. If your credit report has a few problems on it, you may find that another bank may evaluate your credit report differently. A bank's tolerance for risk can vary widely from bank to bank. 3. Equity Most banks want to see that the total liabilities or debt of a business is not more than 4 times the amount of equity. (Or stated differently, when you divide total liabilities by equity, your answer should not be more than 4.) Therefore if you want a loan you must ensure that there is enough equity in the company to leverage that loan. Don't be misled into thinking that start-up businesses can obtain 100% financing through conventional or special loan programs. When borrowing money a business owner usually must put some of her/his own money into the business. The amount an individual must put into the business in order to obtain a loan is dependent on the type of loan, purpose and terms. For example, most banks want the owner to put in at least 20 - 40% of the total request.
The balance sheet indicates the amount of equity or net worth of a business. The net worth of the business is often a combination of retained earnings and owner's equity. In many cases, owner's equity will be shown as a loan from shareholders and therefore a liability. Upon borrowing money, the business owner will be obligated to pay the bank back first and not herself. Consequently, it may be necessary to restructure the liability so that it becomes owner's equity or subordinate the loan. If the current debt to net worth is 4 or over it is unlikely that the business will be able to obtain additional debt/loan. 4. Collateral If a potential borrower has no collateral to secure a loan, she/he will need a co-signer that has collateral to pledge. Otherwise it may be difficult to obtain a loan. The value of collateral when borrowing money is not based on the market value. It is discounted to take into account the value that would be lost if the assets had to be liquidated. The following table gives a general approximation on how different forms of collateral are valued by a typical bank and the SBA:
COLLATERAL COVERAGE RATIO Total Discounted Collateral Value Regardless, the client should be advised to take some time to work in the business first and take some entrepreneurial training classes. QUESTIONS YOUR BANKER WILL ASK The key questions the banker will be seeking to answer when borrowing money are as follows:
SELF-ASSESSMENT CHECKLIST When borrowing money, whether you are applying for a micro-loan, SBA loan or a traditional bank loan, there are certain factors that improve your ability to obtain financing. The following is a simple checklist to do before you begin to seek capital. Do you have a good personal credit history? Yes or No Research indicates that good personal credit history is one of the most important factors in identifying people borrowing money that will repay their commercial loans. Many loan programs require perfect personal credit in order to qualify. For further information refer to Key Points to Consider - Credit History. Have you filed all income tax returns? Yes or No Lenders and government loan programs alike want to see that an individual has met their tax obligations for both filing and paying taxes. For SBA loans tax verification is obtained from the IRS before a loan is closed. Are your Income Taxes paid? Yes or No Many of the loan programs are in partnership with government agencies. These loan programs do not look favorably on individuals who have unpaid income taxes. Does the business have the ability to repay a loan? Yes or No (For existing businesses) If the business is profitable, then there are demonstrated profits to repay some amount of new debt. If a business is not profitable, then it becomes very important to prove how it will be profitable in the near future so that a request for borrowing money can be repaid. (For start-up businesses) It is very important that you find as many data on comparable businesses or industry statistics in order to "prove' the revenues you intend to generate and the expenses you anticipate incurring. Does your business have a positive net worth? Yes or No (For existing businesses) The net worth of the business should be positive when borrowing money. If there are loans from shareholders on the balance sheet and you are able to subordinate these (not pay the shareholders) while you pay the bank loan back, you may consider these loans from shareholders as equity. Is your business not carrying too much debt? Yes or No (For existing businesses) Businesses that have too much debt will find that their profits are directed at paying back loans and not building retained earnings in the business that can fund future growth. Consequently, banks and government loan programs look more favorably owners borrowing money that do not add too much debt to the business. Banks often look for a debt to net worth ratio of 4 or less (total liabilities divided by equity). Do you have enough of your own money in the business? Yes or No (For start-up businesses) All loan programs require that the business owner put their own money in the business. In addition to the borrowed money, this owner equity injection shows that the owner believes in the business enough to risk their own money. Some microloan programs require only 10% owner equity, other programs require at least 30% and will look more favorably on a loan request the more equity is in the business. Do you have collateral to secure a business loan? Yes or No Business and personal assets can be considered collateral when borrowing money, or a way to repay the loan if the business defaults on a loan. Most collateral is valued at an amount less than face value based on a variety of factors. Are you willing to personally guarantee a loan? Yes or No Most business owners are asked for a personal guarantee for borrowing money in order to obtain their first business loan. Does your business have qualified managers and advisors? Yes or No (For existing businesses) As businesses expand, they need more sophisticated management as it relates to strategic planning, borrowing money, marketing, recordkeeping, inventory control, personnel, etc. When you apply for a loan, your banker will consider the qualifications of your management team and advisors in order to determine if they are capable of leading your business to the next level of growth. If there are sectors of your business that you need assistance with, we strongly recommend that you attend entrepreneurial training classes, visit a women's business assistance center or Small Business Development Center in your area, or contact your regional SBA office for information on local resources. Do you have experience in running your own business? Yes or No (For start-up businesses) For a new business, borrowing money especially, it is important for the business owner to demonstrate that she has experience in the industry and/or entrepreneurial experience. If you have never owned or operated a small business before, we strongly recommend that you attend entrepreneurial training classes. STOP! If you cannot answer yes to all the questions above, then you may have difficulties obtaining financing at this time. We suggest that you evaluate the needs of your business and take advantage of local business assistance centers.
More Leadership Articles - Business Planning: »
Applying For A Business Loan »
Free Tool! Management Development Training Needs Analysis. »
Show Me The FREE Money! The Low-Down On Small Business Grant.
Leadership Tools & Resources We're constantly on the lookout for highly effective leadership tools and resources that we can recommend to our readers. Share your own helpful hints and tips here.
Blog/RSS | E-Cards | Interviews | Coaching | Books | Articles | Leader Gifts Self-Help Center | Donation | Advertise | Site Map | Contact Us |
