Lending Insights You Can Bank On
If you’re getting ready to talk to a banker about a business loan, it helps to understand the major factors lenders consider in deciding whether the vault door opens or stays locked -- and whether you’ll leave the bank happy or disappointed.
But before we cover how a bank evaluates your loan application, it’s worth touching on why they’ll subject your request to such intense scrutiny.
No Monkey Business in the Money Business
Banks are businesses, not benevolent organizations. And they’re in business for the same reason you’re in business. To make money. The more, the better.
Their warm-fuzzy ad campaigns notwithstanding, banks care about making your hopes and dreams come true only to the extent that doing so makes their hopes and dreams come true.
Which is why before they drop so much as a dime into your pocket, they’re going to carefully calculate whether you’re a safe bet, whether you’ll be able to repay everything they lend you in full and on time, and whether you’ve got the assets and the character to hold up your end of the bargain.
That’s not greedy or heartless. It’s good business. Banks have a responsibility to act in the best financial interest of their owners and investors. They also have the added complication of being regulated by federal and state government agencies that have a lot to say about the acceptable level of risk in their loan portfolios.
If examiners find that a bank has too many nonperforming (bad) or potentially nonperforming (risky) loans, they can require the lender to increase the money it holds in reserves. Most often, that extra cash comes from the earnings that were supposed to go into the pockets of the bank’s owners. This makes them understandably cranky.
To avoid getting to that point, banks are going to pore over your loan application with the steely, humorless focus of someone defusing a bomb.
Getting Things Started
The ball starts rolling when you fill out a loan application and provide the lender with all the documentation they’ll need to make a decision. While requirements may differ somewhat by institution, most lenders will want to see the following:
Statement of Purpose
Often called the executive summary, it should include:
- Critical details about the loan request, including the amount, purpose, duration, repayment and available collateral
- Brief business description
- Explanation of how the loan will improve the business
- Statement showing the owner’s capital investment (Banks want to see that you've got plenty of your own skin in the game)
Business Plan or Key Excerpts from the Plan
Lenders take business plans seriously, but they won’t take you seriously without one. Here are the sections a bank is most interested in:
- Business description and vision
- Market definition, analysis and sales
- Products and services
- Business organization and management
Key Financial Statements
These tell lenders a lot about the past and current performance of your business, which gives them some basis for forecasting the future. You should include:
- Cash Flow Statement: A current 12-month cash flow statement, projected for at least six months out
- Income Statement: New businesses should show a projected income statement for 12 months. Existing businesses should include income statements for the last three years
- Balance Sheet: New businesses should include a balance sheet for the project opening date and another projected balance sheet for 12 months after launch. Existing businesses should include balance sheets for the last three years
- Personal Financial Statement: Shows your net worth and helps the bank evaluate your financial capacity
But what if you're pitching a startup or you haven't been in business long enough to have that kind of historical financial documentation? Lenders will still want you to provide numbers, but they'll accept pro forma statements with projections. A word of warning: Make sure those projections are realistic, credible, and backed up in you business plan analysis.
Evaluating Your Application
The point of all of the documentation, of course, is to convince lenders that you know what you’re doing, that you’re good at it, that your revenue projections are credible and realistic, that you've got a sufficient level of personal investment and (once you receive the loan) that you’ll have all the financial resources you need to succeed.
In deciding whether you’re a good risk, lenders will evaluate your credit, character, capacity, cash flow and collateral.
Let’s start with your personal credit history. Lenders look askance at late payments, judgments, tax liens, bankruptcy or loan defaults. If you have blots on your credit history that can be fixed, it’s best to do it before you approach a lender. If there are reasonable explanations for those black marks (something beyond your control, perhaps) prepare a formal statement, complete with supporting documentation.
Remember, lenders will look for a pattern here. A history of paying debts on time gives them reason to expect you’ll have the character and commitment to repay this debt in the same way. Likewise, a checkered credit history will spark immediate concerns.
Lenders also assess whether you've got enough financial capacity to repay the loan while continuing to meet all of your other business debts and obligations. That means they’ll be very interested in your income, cash flow, the amount of working capital you have, and the company’s debt compared to the equity you’ve invested.
Your personal net worth also comes into play. It bears on your financial capacity, and it shows lenders that you have collateral – basically, valuable assets the bank can sell for cash – to pledge as security for repayment. Collateral may be assets owned by the business, or the borrower’s personal assets – a home, for instance.
Once you've convinced a loan officer that you’re a good bet, he or she has got to convince the bank’s loan committee. Going through the process is nerve-racking to be sure. But remember, a bank’s success depends on your success. So, if you pass muster, it’s a vote of confidence for you.
Consultants at our Small Business Assistance Office can help you understand more about the basics of loan documentation. And our network of Small Business Development Centers has experts located in nine main regional offices and several satellite centers statewide.
Our Guide to Starting a Business in Minnesota provides a detailed look at this and other important issues.
Watch this 30-minute tutorial on how to prepare a loan package developed by the U.S. Small Business Administration.