Applying For a Business Loan? Things You Should Know

By Bob Rogers, General Business Counselor, SBTDC Asheville

It all started with a paperclip and a small loan.

Playing with a paperclip at his fitness studio, a young man came up with a brilliant, yet simple piece of equipment for abdominal fitness. After fine tuning his concept, he was ready to bring his product to market but lacked one key ingredient: money. 

Undeterred, he worked with a banker to craft a package of microloans, home equity funding, and a small, secured line of credit to launch his product. Though his product was initially offered only on TV infomercials, he ultimately sold tens of thousands of units and became a wealthy man. 

Securing a business loan can be a critical step towards achieving business growth objectives, but the process can be complex and challenging. This article will help you understand what you need to secure a loan for your small business.

What kind of loan should you apply for? 

Small businesses have access to a variety of loan options tailored to their unique needs and circumstances. Businesses should select a loan type that matches the intended use of the funding. 

Why is intended use important? Let’s say a company purchases a piece of equipment utilizing a line of credit. The line of credit only requires them to pay interest on the amount borrowed, with no deadline to repay the principal. Five years later, the equipment needs to be replaced but the company still has the debt from the old equipment on their books since they have only been paying the interest, creating an ongoing expense for an item no longer generating income. Additionally, they’ve lost the ability to access funds needed for temporary cash shortfalls. 

Choosing the right type of loan is important.  

Some common types of loans include:

• Term Loans: Term loans provide a lump sum of capital that is repaid over a set period, typically with fixed monthly payments and interest rates. Term loans would typically be used for things like building purchases. This allows owners to buy large assets and spread the payments over the useful life of the asset. 
• Lines of Credit: Lines of credit offer businesses access to a predetermined credit limit, allowing them to withdraw funds as needed. Interest is only charged on the amount borrowed. Lines of credit are helpful for short term cash flow needs, such as seasonal fluctuations in sales.
• Equipment Financing: Equipment financing specifically covers the purchase of machinery, vehicles, or other assets, with the equipment itself often serving as collateral for the loan. The term of the loan should match the useful life of the equipment purchased.
• SBA Loans: Small Business Administration (SBA) loans are government-backed loans that offer favorable terms and lower down payments, making them an attractive option for many small businesses. There are several different types of SBA loans designed to address specific borrowing needs.
• Microloans: Microloans provide smaller amounts of capital, typically between $500 and $10,000, to startups and small businesses, often with lenient requirements and terms. 

What information will banks require? 

A well-prepared loan package is essential for presenting your business effectively to lenders and increasing your chances of approval. Financial Institutions expect you to provide the following:

• Business Plan
• Financial Statements
• Tax Returns
• Credit Reports
• Collateral Documentation
• Personal Financial Statements

A well-crafted business plan provides lenders with insights into the business’s goals, market analysis, financial projections, and growth strategies. A comprehensive business plan enhances credibility and improves your chances of obtaining a loan.

For detailed information on crafting a business plan, review our Business Start-Up Guide. The NC SBTDC can provide guidance to assist business owners in preparing their Business Plan and financial projections.

How do bankers make their loan decisions? 

Banks evaluate loan applications based on various criteria to assess the borrower’s creditworthiness and the risk associated with lending to the business. Common factors considered during the application process include:

• Risk Assessment: Lenders assess the level of risk associated with lending to the business based on factors such as credit history, financial stability, industry trends, and market conditions.
• Financial Stability: Lenders examine the business’s financial statements, cash flow projections, and profitability to determine its ability to repay the loan.
• Creditworthiness: Lenders evaluate the borrower’s creditworthiness based on their credit score, payment history, and debt-to-income ratio.
• Business Plan Viability: A well-crafted business plan demonstrates the viability of the business, its growth potential, and the strategies for success.
• Collateral: Collateral provides security for the loan and reduces the lender’s risk. It can include assets such as real estate, equipment, or inventory.
• Cash Flow Projections: Lenders assess the business’s cash flow projections to ensure it has sufficient revenue to cover loan payments.
• Repayment Capacity: Lenders evaluate the borrower’s ability to repay the loan based on their income, assets, and financial stability. While all these factors are considered, repayment capacity is arguably the most important consideration.

What financial information do banks focus on? 

Lenders often analyze a business’s financial statements and key ratios to assess its financial health and ability to repay the loan. Some essential financial ratios and profitability levels that lenders may consider include:

• Debt Service Coverage Ratio: DSCR is a financial metric used by lenders to evaluate a company’s ability to cover its debt obligations with its operating income. To calculate the Debt Service Coverage Ratio, you divide a company’s operating income by its total debt service obligations. Banks typically look for a DSCR of 1.25 or higher.
• Debt-to-Equity Ratio: This ratio measures the proportion of debt used to finance the business compared to equity, also referred to as “skin in the game.” A lower debt-to-equity ratio indicates lower financial risk. While it varies among lenders, most financial institutions look for a debt-to-equity ratio of 1:1. 
• Current Ratio: The current ratio measures the business’s ability to meet short-term financial obligations. A higher current ratio suggests better liquidity and financial stability. To calculate the Current ratio, you divide a company’s current assets by its current liabilities. A 2:1 current ratio is considered strong.

What are some “Red Flags” that lead to declined loans? 

Lenders look out for red flags that may indicate financial instability or increased risk when reviewing loan applications. Some common red flags include:

• Inconsistent Financial Statements
• Poor Credit History
• Insufficient Collateral
• Unrealistic Revenue Projections

Identifying and addressing these red flags before applying for a loan can improve your chances of approval and help you secure more favorable loan terms.

What to do if you’re turned down: 

If your loan is declined, it’s important to speak with your loan officer to understand the rationale behind the decision. Often, there are mitigating factors that can be addressed to enable you to obtain financing. For instance, substituting a guarantor or offering additional collateral may improve the likelihood of approval.

Even if the current application cannot be salvaged, the loan officer’s feedback will provide valuable information for future borrowing opportunities. Develop a strategy to address the shortcomings communicated by the lender.

Additionally, developing a strong relationship with loan officers can play a role in future approvals, although their influence is secondary to the independent underwriting process.

Seeking guidance from reputable sources such as business counselors from organizations like the SBTDC, as well as financial advisors and accountants, is advisable. These professionals can offer strategies to improve your creditworthiness and your chances of securing financing in the future.

How can I improve my business credit rating? 

Like individuals, businesses can have credit ratings. Banks use these credit ratings when making loan decisions. Steps businesses can take to improve their credit ratings are very similar to the tactics recommended for individuals. Paying bills on time, maintaining low debt levels, and making your loan payments on time are crucial steps to improving your rating. Credit scores are also enhanced by varying your business’s types of credit, including business loans, vendor credit, lines of credit and business credit cards. It is also beneficial to reduce the use of personal credit in your business.

Finally, if you find your business in a difficult financial situation, communicate with your lender. Banks are sometimes willing to provide relief in the form of debt restructuring to reduce monthly loan payments.  

What can I do if traditional lenders will not provide financing? 

If you can’t qualify for traditional lending, there are other options to explore. Community Development Financial Institutions (CDFI’s) are financial institutions that provide funding for underserved communities and businesses, such as start-ups, that have difficulty obtaining traditional financing. 

Some financial institutions offer factoring and invoice financing. This enables businesses to borrow against their receivables. Business credit cards are another source of credit. Peer to peer lending has become more common. This connects borrowers with individual investors who lend money to businesses.

Equity investors provide another funding source. Crowdfunding and Angel Investors are often used by small and mid-sized businesses.

Finally, there are many private and public grant programs designed to help businesses. Be advised that many grant programs are designed specifically to aid underserved areas or groups of people and can be difficult to qualify for.

In conclusion 

Obtaining a loan can be challenging for a small business owner. Knowing what banks are looking for and coming in prepared are important steps to enhance your chances for approval.

Follow these recommendations and who knows? Maybe you can turn a paperclip into a fortune.