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.
Profitability
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.
Liquidity
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.
Leverage
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:
Turnover
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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