Article - What Makes a Good Business Loan?

By Karl Wernick

Over the course of my years of commercial loan experience with the Small Business Administration (both in originating loans and on the “tail end” of things when some borrowers’ rose-colored glasses failed) I was frequently asked the question, “What do you look at when making a loan?” I was expected to provide an answer in 50 words or less. Of course, if loan decision criteria consisted of only a handful of things the decision process would be easy. In reality, some loan decisions are a “slam dunk” whereas others are more difficult. However, there are some basic criteria which, if met, are indicators of a strong loan proposal.

Capacity to repay the loan obligation weighs heavily on the minds of lenders looking at loan proposals (unless they are in the business of making unintentional grants). Clearly, an enterprise which fails to demonstrate ability to repay a loan probably won’t (and shouldn’t) get one! Lenders make a living by actually getting back their principal plus interest earned. Consequently, they prefer to lend based on the borrower’s ability historically to generate sufficient cash flow to satisfy both his existing and proposed obligations. In some instances, the lender may accept proforma cash flows based upon reasonable assumptions.

Typically, a lender will require some kind of “slush factor” in the cash flow calculation. This means that total projected cash flow must exceed projected payments by a certain factor. A rule-of-thumb minimum coverage ratio would require $1.20 or $1.30 in cash flow for every dollar of projected debt service. This serves as additional “insurance” in the event the business fails to achieve its projected (or historical) level of profitability. The lender will also consider internal and external factors such as changes in management or key personnel, ageing (or outdated) production equipment, product obsolescence, general economic conditions, or competitive forces. Any one of these may impact the business’s capacity to repay its obligations.

Well founded, honest and balanced management is critical to success of a business. Often entrepreneurs establish a business based on their expertise in the product or service they plan to provide but fail to understand that there is more to running a business than knowing how to “cook up a great burger” or “make that engine purr like a kitten”. Strong product knowledge is definitely important but it is only one of several areas in which management needs to be knowledgeable.

Since most small businesses begin with very limited management resources they often do not have all knowledge key to their success such as how to adequately market their product, how to properly manage employees, how to organize their business legally (e.g. S-corporation, C-corporation, partnership, LLC, sole proprietorship, etc.) and other legal issues, how and where to obtain financing, and how to engage in proper accounting procedures. All of these are important and lack of knowledge in any one area can spell disaster. Unless the business owner is a “master (not just a “jack”) of all trades” it is important that he/she surround him/herself with professionals who have the required expertise to enable success.

A favorable credit history both for the business and its owners is also a key decision factor. Individuals and businesses which have a history of meeting their loan obligations are much more likely to be granted credit than those who fail to make their payments on time, have judgments filed against them, or have petitioned the court for bankruptcy.

The owner’s equity in the business is important for two reasons. First, a personal financial commitment to the business typically ensures that the business owner will work harder, faster and longer to make his business succeed. Throwing in the towel and admitting business defeat is much easier for an owner if he/she stands to lose nothing financially. Second, more equity means less debt which typically translates into improved repayment capacity. A business that can show a 30% equity position on its balance sheet has much less debt to service than one that has only 5%. The first business has some leeway to weather a storm the second does not. Obviously, all other things being equal, a lender will look more favorably at a loan request from the first business than from the second.

The lender will also typically calculate all sorts of ratios and common size financial statements to help him analyze the business’s operations such as how quickly the business pays its suppliers, how much inventory is on hand, how much profit is generated as compared to assets, sales, or equity, etc. Performance results are compared with those of other enterprises in the industry and are also evaluated independently to assess the business’s financial health.

Finally, lenders evaluate secondary sources of repayment such as collateral and individual guaranties. Secondary sources of repayment constitute a “backup plan” to recover the lender’s money in the event the business fails to make required payments. Typically, lenders extend loans based upon a percentage of an asset’s value which percentage varies with the asset type, as well as its useful life, location, and condition. While some lenders specialize in loans secured by certain types of collateral such as equipment, inventory, accounts, etc., most strongly prefer real estate. Individual guaranties of the business owners are required both to ensure the borrowers’ commitment and as a source of repayment in the event of a loan default.

The business owner may say, “I’ve just started my business and probably can’t get a loan because I have poor equity (limited collateral, no history of repayment, etc.)” Just as people have their strengths and weaknesses, relatively few businesses score well on all counts. For this reason, loan making is a somewhat subjective process despite the fact that we lenders tend to “crunch” a lot of numbers. Consequently, the business owner should not sell himself short and should let the professional determine if the loan can be made. The former may be absolutely correct in his assessment of having an inadequate equity position. However, a lender may be able to overcome weakness in this area with strength in another area (or several). Alternatively, if the weakness cannot be overcome the lender may suggest remedial action which, if taken, can improve the business’s ability to borrow in the future. Remember that the lender makes his money by – you guessed it -- lending money. Once the lender feels reasonably assured that the loan will be repaid in a timely manner, the business owner gets the money he needs to grow and the lender develops a profitable relationship. Consequently, most lenders want to create a “win-win” situation!