In the last article in our series on financing your business, we looked at how to finance an existing business with merchant cash advances and factoring. In today’s article, we are going to continue this series with a look at how to get a small business loan from a bank.
Banks don’t like lending to small businesses and are doing less and less of it.
Getting a “small business loan” is much harder today than it was a few years ago. In 2008, there was $336 billion in non-real estate related small business loans. That number has declined tremendously since then, although there has been a small upswing in outstanding small businesses in since 2013, but the numbers are still much lower than what we saw in 2008. In 2013, there was only $289 billion in such loans outstanding, according to a Small Business Administration (SBA) report.
Many of these loans may not even be to what you or I would consider a small business. To be categorized as a small business loan, the amount of the loan simply needs to be less than $1 million dollars regardless of the size of the business. When the amount of the loan is dropped to $250,000 or less, there was only $171 billion in small business loans outstanding in 2013. This is less than 7% of the total amount of loans made by banks.
Minimum Eligibility for A Bank Loan and Alternatives
One of the ways that banks are loaning to fewer and fewer small businesses is by raising the eligibility requirements. In general, you need the following at minimum to qualify for a bank loan:
- You must be in business for at least 2 years.
- You’re going to need to have a business plan and detailed financial data.
- You will have to personally guarantee the loan and in many cases, pledge collateral.
- You should have a great personal credit score — at least around 640.
These are minimum requirements. Below, we describe additional financial data that most banks will want to see in a loan application.
If you don’t meet one or more of these requirements, there are alternatives to a bank loan. If you’re a startup, you can try peer-to-peer lending, microloans from a nonprofit, or any of the options discussed here. If you don’t have a great credit score, alternative lenders such as OnDeck and Kabbage offer loans for business owners who can’t qualify for a bank loan (Kabbage also doesn’t require personal guarantees). Finally, if you don’t have sufficient collateral but meet the other requirements, an SBA loan might be the best option for you.
Personal Guarantee and Collateral
A personal guarantee means that you are personally on the hook for paying the business loan back. You have to pay it back even if your business is unsuccessful and closes down. If you don’t pay back the loan, the bank can repossess your personal assets (e.g. your home and car) and sell them off to satisfy the loan.
Collateral is provided as security for a loan in the case of default. In some cases, business assets serve as collateral. This includes your business’ office, equipment, machinery, and inventory. If your business assets do not provide sufficient collateral, the bank may want you to provide personal assets to collateralize the loan as well. Usually, what happens in the event of a default is that the bank will first foreclose on your collateral and then collect the remainder of the loan balance, if any, by enforcing the personal guarantee.
How to Get A Small Business Loan Or Line Of Credit From A Bank
The bank is going to run your loan application and financial data through a computer. If your business doesn’t meet certain criteria, such as numerical ratios, the loan will automatically be rejected. The most important ratio is debt service coverage ratio (DSCR).
Definition of Debt Service Coverage Ratio:
Total Net Cash Income (your annual profits after subtracting non-cash additions to income, before income taxes) Divided By Your Debt Service (the amount of the money you will need to pay in interest and principal over the year).
To approve your loan, most banks will want see that you have a debt service coverage ratio of 1.25 or higher.
Let’s say your business is making profits of $50,000 per year. Banks will generally not provide you a loan which will require more than $40,000 in payments per year. How big a loan can $40k in annual payments support? About $250,000 (assumes a 7 year terms, 10% interest rate, and the loan paid over during its life).
To figure out the size of the loan that your business might qualify for, you can use a mortgage calculator to figure out the payments. You should keep in mind that business loans are generally for much shorter periods of time than home loans. Typically, a business loan will be for 3 to 10 years. Additionally, business loans typically carry a higher rate of interest.
What if your business does not yet have a positive net income or not enough to take the size of loan you want?
This is where your business plan comes into play. You must be able to convince a banker (who are an extremely skeptical bunch) that the loan will put you in a position to generate more cash flow and income. The bankers look closely at your business history to see if the numbers support this assertion.
First and foremost, banks want to make sure the business has enough cash flow, but they also want to make sure they can collect in the “worst case” scenario.
The DSCR is only one of many financial ratios which banks carefully scrutinize to satisfy themselves that you are not a risky borrower. Other ratios measure the bank’s ability to collect on the loan if the borrower is unable to make payment from cash flow.
If the loan is for the purchase of real estate, the bank will generally not want the loan-to-value (LTV) to be more than 0.8. In other words, the loan should be for less than 80% of the value of the property. When commercial real-estate is not supporting the loan, banks want the business to have an even lower debt to assets ratio. The closer this ratio is to 0.5, the more likely a bank will approve the loan.
Other Factors That Go Into Getting A Small Business Loan Approved
- The background of the owners (including credit history).
- The experience of the executives.
- The amount of personal investment that the owners have put into the business.
- The amount of personal collateral that the owners are willing to pledge to secure the loan.
These factors are explored in detail the article Borrowing Money For Your Business from the SBA.
That’s our article for today. If you have any comments or questions please leave them in the comments section below. Also be sure to stay tuned for my next article where I will begin our series on how to market your business offline..