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The Credit Process: A Guide
For Small Business Owners

... Continued From Previous Page

What The Lender Will Review

Credit Analysis

Regardless of where you seek funding—from a bank, a local development corporation, or a relative—a prospective lender will review your creditworthiness. A complete and thoroughly documented loan request (including a business plan) will help the lender understand you and your business. The basic components of credit analysis, the "Five C's," are described below to help you understand what the lender will look for.

The "Five C's" of Credit Analysis

  • Capacity to repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships—personal or commercial—is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.

  • Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.

  • Collateral or guarantees are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can't repay the loan. A guarantee, on the other hand, is just that—someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan.

  • Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender also will consider the local economic climate and conditions both within your industry and in other industries that could affect your business.

  • Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience levels of your employees also will be taken into consideration.

Financial Analysis

In addition to the "Five C's," a prospective lender will use four primary financial statements to make a credit decision.

A Personal Financial Statement

Indicates your net worth. Each partner or stockholder owning a substantial percentage (for example, 20 percent or more) of the business should submit one. A personal financial statement is important to the lender, particularly if you have never received financing for your business before, because it gives the lender evidence of personal assets you could pledge to secure a loan.

A Balance Sheet

Provides you with a snapshot of your business at a specific time, such as the end of the year. It keeps track of your company's assets, or what the company owns (including its cash), and the company's debts, or liabilities (generally loans from others). It also shows the capital, or equity, put into the business.

A Profit and Loss Statement

Shows the profit or loss for the year. The profit and loss statement, also called the income statement, takes the sales for the business, subtracts the costs of goods sold, then subtracts other expenses.

A Statement of Cash Flows

Presents the sources of cash in your business—from net income, new capital, or loan proceeds—versus the expenditures, or uses of the cash, over a specified period of time. An example of the cash flow statement for F.E.D. Foods Company is shown below.

It's at this stage that you will appreciate having an effective accounting system. Without this system, you won't know if you are profitable or not, let alone if you are liquid enough (simply put, have enough cash on hand) to pay for the next order of merchandise. A good system also will help you track your company's growth and anticipate future cash needs.

Ratio Analysis

Another tool the lender will use is financial ratio analysis. Ratios permit review of a company's current financial performance versus that of previous years. In the same way that a medical checkup tests one's heart, lungs, and changeable factors such as body weight, an analysis of a company's financial performance considers the status, changes, and relationships of critical components of a company's health.

The lender also may use financial ratio analysis to consider how a company is doing when compared to another company. A limitation of such comparative analysis is that different industries are driven by different factors. As a result, the financial ratios of a manufacturer and retailer can be quite different even though both companies may be similarly successful.

Lenders are trained to appreciate both the benefits and limitations of ratio analysis and to consider financial results in the context of the company's "peer group" of similar companies within its industry. To find out what the benchmarks are for your type of business, you may refer to guides published by Robert Morris Associates and others.

The following section presents some widely used ratios from four financial ratio categories: profitability, liquidity, leverage, and turnover. The section also provides examples of the ratios calculated for the sample company, F.E.D. Foods Company. Your lender's analysis also may include ratios specific to your particular industry.


Profit is the compensation an entrepreneur receives for the assumption of risk in a business venture. The profitable business must cover its overhead expenses and generate profits for its owner out of its "after-product-costs" cash.

Gross Profit Margin

One commonly used measure of profitability is gross profit, which is your sales minus your product costs. In ratio form, it is called the gross profit margin.

Operating Profit Margin

Another measure of your profitability is the operating profit margin. This is the core cash flow source that is expected to grow year to year as your business grows, and it excludes interest expense, taxes, and "extraordinary items" such as the sale of property or other assets.

Higher profitability from one year to the next is generally considered a good sign for a company.


How much cash does your business have on hand for immediate use?

Quick Ratio

The quick ratio shows what assets your business can immediately convert to cash, such as the business checking account and money market accounts.

Current Ratio

The current ratio is a broader indication of liquidity because it includes inventory. For purposes of showing your immediate access to cash, many lenders find it less useful than the quick ratio. In general, lenders look for your current assets to exceed your current liabilities.


The leverage ratios measure the company's use of borrowed funds in relation to the amount of funds provided by the shareholders or owners. These ratios tell the lender how much money you have borrowed versus what money you and other owners have put into your company. This is important because borrowed money carries interest costs and your business must generate sufficient cash flow to cover the interest and principal amounts due to the lender. Generally speaking, companies with higher debt levels will have higher interest costs to cover each month, so low to moderate leverage is nearly always viewed more favorably by prospective lenders.

Debt Ratio

The most common leverage ratio is called, simply, the debt ratio:


The turnover ratios focus on the operating cycle of your business by examining its cash flow. They show the amount of time it takes for cash to move through the accounts receivable, inventory account, and accounts payable in your business.

It is important to know how many days it takes your company to purchase inventory, pay for it, sell it, and collect the cash for the sales. Those sales you make on the customer's promise to pay at a later date (also known as credit sales) may not actually produce cash for 30 to 60 days. You can get squeezed if you don't understand this cycle and find that you have to pay for new supplies before your customers have paid you.

Gaining an understanding of the cash flow of your business is the most important financial planning tool you have. An examination of the turnover ratios can help you to understand the operating cycle in your business.

The three turnover ratios are the collection period ratio, the days to sell inventory ratio, and the days purchases in accounts payable ratio.

Collection Period Ratio

First, the collection period ratio indicates how quickly you collect the cash your customers owe you. The earlier you collect it, the sooner you can put it to work purchasing more inventory or paying for current orders; so the lower the number, the better.

Days to Sell Inventory Ratio

Along the same lines is the second turnover ratio, the days to sell inventory ratio. The days to sell inventory ratio tells how efficient you are at matching your purchases to your sales. Low inventory days indicate that you've accurately forecasted the demand for your product. That way excess inventory isn't accumulating on your shelves and adding to costs.

Days Purchases in Accounts Payable Ratio

The days purchases in accounts payable ratio is the third turnover ratio. This ratio measures how quickly you pay your suppliers for inventory purchased. Generally speaking, it is advantageous for small businesses to pay for products promptly so they can take advantage of price discounts.

Pro Forma Financial Statements and Financial Projections

Pro forma financial statements are the entrepreneur's best guess about what next year will look like for the business. These tools will help you anticipate whether next year's cash flow will be sufficient to cover all your costs, and if not, how much money you will need to borrow.

For a longer horizon, financial projections permit you to make estimates about future sales levels, expansion costs, or general business conditions and see how such conditions would affect your company's financial results in the years to come.

The preparation of pro formas and projections is a complex exercise that requires a sound knowledge of financial accounting. A comprehensive discussion of these tools is beyond the scope of this text. However, with the help of your accountant or the advice of one of the sources listed in the Information Guide, the exercise can provide both you and your potential lenders with valuable insights into your business.

These are pro forma financial statements for F.E.D. Foods Company, which expects its sales to increase by 25 percent for 1994. The pro forma statements show how an expected sales increase will change the company's profit and loss statement and balance sheet forecast for next year.

Resources and How to Use Them

There are numerous programs available to assist prospective and existing small business owners. Many are wholly or partially funded by federal or local government entities and can provide services to you at low or no cost. Sometimes staffed by university professors and graduate business students, retired business executives, or small business consulting specialists, these programs are excellent sources of advice. An abbreviated list of resources in your area appears in the Information Guide

Types of Assistance

Small business assistance programs generally fall into two categories: training programs, which teach business owners technical and financial skills, and loan programs, which offer loans or loan guarantees for small businesses.

Training Programs

Depending on the organization and on your particular needs, training programs offer skill—building assistance either in the classroom for several weeks or in individual counseling sessions.

Technical assistance programs can cover a wide range of topics and their applicability depends on the nature of your business. Topics may include production, marketing, distribution, packaging, import/export documentation, and human resources or staff management.

Financial skills assistance programs may include basic accounting, cash flow management, sales projections, feasibility studies, and tax planning.

Business plan development courses include components of both the technical and financial programs and assist you with composing, preparing, and presenting your business plan and loan proposal to prospective lenders.

Loan Programs

Loan programs are among the resources offered by small business investment corporations and state or local development corporations. These programs typically have funds available to lend directly to new or expanding businesses. They also may offer guarantees or other support for a loan given by a traditional lender, such as a bank, to help mitigate the bank's risk of lending directly to a new small business. One advantage of approaching an organization with a loan program rather than a bank is that the organization may have funds dedicated solely to the new small business market. It also may be receiving some type of government subsidy that permits it to offer lower interest rates for small business loans. Programs that provide guarantees from a government agency to pay the loan if your business fails may convince a bank to lend to your business when it otherwise would't.

Small Business Administration

Created in 1953, the Small Business Administration (SBA) provides management and financial assistance to small businesses. Mainly, the SBA guarantees loans through financial institutions. The loans may be used for working capital, machinery and equipment, acquisition of real estate, and expansion.

If Your Application Is Not Approved

If your loan is not approved, ask why. You are entitled by law to a written statement of the reasons for a loan denial, if you request it. Many banks automatically supply the reasons for denial in writing.

Knowing the reasons for a loan denial can inform you of areas in your proposal that didn't meet the lender's standards. Since all lenders do not share identical standards, another lender may reach a different credit decision. Review your loan proposal in light of the lender's comments. See how you can use the resources or ideas presented in this booklet to strengthen your application. Go through the process of reviewing your technical and financial material again, and then review your business plan. Find any areas that could be augmented further and lead to an approval on your next request.

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