Originally published in American City Business Journals
By Mark Abell
Small business is booming, with thousands of U.S. businesses seeking loans for capital to expand or to fund acquisitions.
For the first eight months of this year, small business loans guaranteed by the U.S. Small Business Administration’s 7(a) program topped $23 billion, up 7.1 percent from the same period in 2016.
With the current economic expansion having lasted for eight years, this stage in the business cycle is when we typically see a great deal of business activity. It’s a good time for owners that want to sell their business because prices are high. It’s also a great time for firms that want to expand to get the credit needed to make their plans a reality .
Today, 64 percent of small business loans support established businesses — not startups — and the owners busy running these firms often don’t think much about what they might need to do in advance of getting a bank loan. However, business owners need to be prepared when opportunity knocks. After all, if you cannot line up credit when opportunity comes, it will pass you by.
Be prepared
As a banker dealing with business loans, I’ve seen countless applications declined because owners were not prepared. A survey by regional Federal Reserve Banks reveals accessing necessary credit is the No. 1 challenge facing small businesses.
Among businesses with revenue of more than $1 million, 72 percent were able to secure the financing they needed in 2016. Among smaller firms, 55 percent were turned down for a loan.
In my experience, smaller businesses often struggle to understand the process of preparing a strong application, and this impacts their ability to get funding.
A successful bank loan application starts with meticulous financial records. Owners should always have business and personal tax returns and three years of business financial statements on hand, as well as current year-to-date financials with prior year comparisons that are annotated to explain any anomalies.
I recently had an applicant who owned one college-town restaurant and wanted to acquire another one but had declining revenue in the existing location. We got comfortable with the loan because the owner explained that in order to avoid underage drinking problems that other local businesses had experienced, he had chosen to close earlier rather than risk running afoul of regulations.
Have sufficient cash flow
Those who own or have a share in multiple businesses need three years of records available for all of their businesses, since underwriters need to see the owner’s entire financial picture and document that the owner’s other businesses will not cause the owner to redirect the borrower’s cash flow to support their other businesses. The No. 1 reason most loan applications are rejected is because there is not sufficient cash flow to support repayment.
In cases where the business is seeking growth capital, the bank may require a business plan with detailed projections to demonstrate the cash flow will be there once the business is expanded — something that local Small Business Development Centers and SCORE Association chapters can help prepare. In addition, the firm should prepare a debt schedule (including leases), accounts receivable and payable, as well as an inventory report for the bank.
The application should explain how funds will be used and identify any contracts that will support repayment. If the loan is to expand into a new market or region, the business plan should include research explaining the pros and cons of the new location and how it might differ from the company’s home base. Business owners should never sign leases in new locations without doing this type of due diligence in advance and preferably lining up the appropriate financing.
Personal credit scores and collateral
Business owners also need strong personal credit scores since banks view personal credit as a reflection of their character and willingness to repay their creditors, and it is the person, not the business, who decides who gets paid first when cash flow is tight. Improving scores before seeking a loan can be critical to the success of your business application, and improving those scores can be pretty simple.
For owners who carry balances on credit cards, reducing outstanding balances to less than 30 percent of available revolving credit limits will typically result in a large improvement in personal credit scores. Similarly, for those who pay their cards off monthly, paying a few days before the due date will result in a much lower balance being reported to the bureau each month.
Since loans require collateral, owners should know in advance what they have available and, if needed, increase collateral. Underwriters typically accept 50 percent of the value of raw materials and finished goods inventory, 70 to 80 percent of accounts receivable, and 50 to 80 percent of fixed assets such as equipment, machinery, furniture and office equipment.
Reduce debt
SBA-backed loans are more flexible on collateral and can make the difference in getting to an acceptable cash flow to approve the loan. That’s because while conventional loans typically have five-year terms or less, SBA loans can have a term of up to 10 years for most purposes, helping reduce the debt payments to a manageable level.
Banks don’t like businesses to take on more than $3 or $4 of debt to every dollar of equity retained in the business. However, many small businesses don’t meet this mark because the owners withdraw all excess cash flow in the form of compensation or distributions.
Owners can help overcome this challenge by offering to contribute a down payment on the project being financed, by taking a lower salary or distributions so they leave more cash in the business, or showing they have personal savings funded by the business that can act as a proxy for equity because it can be contributed back to the business if it experiences challenges.
Getting a small business loan is a balance of having the right data on hand and the compelling narrative that makes underwriters comfortable that the loan will ultimately get repaid. Doing a little preparation in advance will make life much easier when the perfect business opportunity comes along.
Mark Abell is senior vice president and SBA division director at NBH Bank , Member FDIC, Equal Housing Lender. NBH Bank serves clients through Bank Midwest, Community Banks of Colorado and Hillcrest Bank.