The Credit Process: A Guide
For Small Business Owners
Some say owning a home is the American dream. Millions of small business owners will argue, however, that owning one's own business is really the American dream.
But while it offers rewards, owning a business is not easy. Entrepreneurship has its problems, and a criticaland sometimes fatalone for small businesses can be the lack of access to the financial resources to keep the dream going.
The purpose of this article is to assist small business owners or entrepreneurs who are seeking outside financing for the first time. Our goal is to highlight information that prospective borrowers need to know about the credit process before they apply for a loan.
While a comprehensive discussion of accounting, finance, and marketing fundamentals is beyond the scope of this booklet, we have presented an overview of these concepts as applied to a small business. The sources and types of funding typically available to small businesses are covered along with a discussion on creating a business plan.
Sources and Types of Funding
Where to Borrow
Getting credit for a business can be a dilemma because until you've developed a good track record with business credit, many commercial banks and other traditional lenders will be reluctant to extend credit to you.
In order to identify the type of financial institution most likely to lend to your business, it's helpful to pinpoint which of the four early stages of development your business is in.
Stages of a Developing Business
Stage one businesses are start-ups.
Stage two businesses have business plans and product samples but no revenues.
Stage three businesses have full business plans and pilot programs in place.
Stage four businesses have been in operation for some time and have documented revenues and expenses.
Lenders suggest that rather than approaching a bank,
owners of businesses in stages one and two should seek
financing from informal investors. Such sources of funding
may include friends or relatives, partners, local development
corporations, state and local governments offering low-interest
micro loans, private foundations offering program-related
investments, credit unions featuring small business
lending, and universities with targeted research and
Lenders say that businesses in stage four, and some in stage three, are sufficiently developed to approach a commercial bank or another traditional lender for a loan.
If your business is in stage three or four and you
intend to approach a commercial bank, lenders suggest
that you first submit an application to a bank with
which you have an established relationship. If you do
not have an established relationship with a bank, lenders
recommend that you ask an experienced accountant or
lawyer to contact a bank and present your proposal.
Also, keep in mind that you must choose a legal designationsole
proprietorship, partnership, or corporationand
execute the necessary documentation for your small business
before approaching a bank or another lender.
Reason to Borrow
There are three major reasons why businesses borrow; the first and most common reason is to purchase assets. A loan to acquire assets could be for buying short-term, or current, assetssuch as inventoryand would be repaid once the new inventory is converted into cash as it is sold to customers. Or, the funds could be for the addition of long-term, or fixed, assets, such as equipment.
The second reason is to replace other types of credit.
For example, if your business is already up and running,
it may be time to take out a bank loan to repay the
money you borrowed from a relative. Or, you may wish
to use the funds to pay suppliers more promptly to get
a discount on the price of the merchandise.
The third reason is to replace equity. If you wish
to buy a partner's share in your business but you don't
have the cash to do it, you may consider borrowing.
The purpose of your loan is critical in determining
the type of loan you request. You also should make sure
that the timing of the repayment schedule on your loan
matches the incoming cash flow you will use to make
There are a number of loan types available to commercial
borrowers, including lines of credit, seasonal commercial
loans, installment loans, collateralized loans (which
are secured with assets), credit card advances, and
term loans. Regardless of the type, most loans have
the following features.
Common Loan Features
- Loans are long term or short term.
- Interest rates vary depending on the term, type, size, risk of the loan.
- Repayment may be a lump sum or on a monthly or quarterly schedule.
- Payments may be delayed until the funds help your business generate cash flow.
- The loan may be committed, meaning the bank agrees to lend to you under certain terms as you need funds without requiring you to re-apply each time.
- Some loans require that you maintain compensating balance levels in a deposit account.
You also should be aware that the lender will expect
you to agree to certain performance standards and restrictions
in order to ensure that your business can repay the
loan. These restrictions, known as covenants, representations,
and warranties, commonly include the following.
Common Loan Restrictions
- Maintenance of accurate records and financial statements
- Limits on total debt
- Limits on total debt
- Restrictions on additional capital expenditures
- Restrictions on sale of fixed assets
- Performance standards on financial ratios
- Current tax and insurance payments
- Restrictions on dividends or other payments to owners and/or investors
The First Step: Preparing Your
Business Plan and Loan Request
When you apply for a business loan, you
will need to provide certain information about yourself
and your business in the form of a business plan. A
business plan can act as an ongoing management guide
to help you establish production goals and measure actual
performance. Your business plan can help demonstrate
to a prospective lender that you have the knowledge,
managerial competence, and technical capability to run
a successful business.
The plan must be thorough and well organized. The finished
document should be typed and placed in a binder. Make
several copies for each of your prospective lenders
and keep several copies for your files. Lenders recommend
that you prepare the plan with the help of your accountant
or a professional at a small business development center.
The Business Plan
The business plan should include the following sections:
- Title page. List the name of the business, the owner(s), the address, and telephone and fax numbers.
- Executive summary. Provide a brief summary
of the plan and tell the reader how it is organized.
The executive summary should be written last because
it will draw on the other parts of the business plan.
It tells who you are, the function of the
and gives a summary of your purpose for borrowing.
- Company description. Give an overview of
the function and history of your company, its size,
products or services, and markets.
- Market analysis. Present your research and
a discussion of the conditions and trends within the
industry. Review the market for your product and the
demand for it. Describe how many major competitors
you have, how much of the market each of your competitors
controls, and your strategy for gaining a share of
the market or developing a new niche. You should be
able to explain any barriers to entry into new markets
you are considering and how you plan to overcome them.
- Products and services. Explain your product or service and its function.
- Operations. Explain how you make your product
or provide your service. Specify how you get your
product out the door to the customer. Where will you
get your raw materials or inventory? If a manufacturing
process is involved, describe it here, including the
size of the factory, stages of production, and work
flow. Or, if you have a retail business, give the
location of your store. How was the site selected?
Where will inventory be warehoused?
- Marketing plan. Describe how you intend to
sell your product or service and who will buy it.
Also, discuss your distribution plans, advertising
arrangements, and sales force.
- Ownership. Indicate what type of legal entity
your company is and its ownership structure: sole
proprietorship, partnership, or corporation. If you
have partners, who are they? How much of your company
do they own? Describe how these individuals became
principals and what you have agreed to give them in
return for their investments.
- Management and personnel. Review who is in
charge, who works for you, and why you hired them.
Describe how their experience will contribute to the
success of your business. Include resumes of key people,
- Funds required and expected use. Summarize
why you need a loan and how you will use the money.
Ask for a specific amount. Include documentation on
collateral, guarantor agreements, and signed contracts.
Describe your repayment plan and present a contingency
plan should your initial source of repayment fail.
- Financial statements and projections. Include
a personal financial statement, personal tax returns,
and business financial statementsbalance sheet,
profit and loss statement, cash flow analysis for
the last three to five years (if you have been in
business that long), and projections for the expected
performance of your business for the upcoming three-year
In this section you will need to demonstrate your
understanding of basic accounting and the financial
concepts that are crucial to the success of your business.
By using complete and correct financial statements,
you will be able to communicate to a prospective lender
how these concepts are successfully applied in your
- Appendices/exhibits. This section should
document any issues that can't be addressed in the
text. For example, distribution agreements, contracts
for the purchase of your product, and your operating
licenses would all be included as appendices.
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