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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 critical—and sometimes fatal—one 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 development funds.

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 designation—sole proprietorship, partnership, or corporation—and 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, assets—such as inventory—and 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.

Loan Types

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 the payments.

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.

Loan Agreements

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

    company, 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, including yourself.

  • 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 statements—balance 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 period.
  • 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 business.

  • 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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