Think like your lender to understand how to land financing

As critical as it is in a lender’s decision making process for a term loan, what is often misunderstood by the owners of small and sometimes larger privately-held businesses is the need to have sufficient working capital to operate and an appropriately-balanced debt structure for the business.

The balance sheet must, then, have two kinds of balance. Obviously it must be assembled correctly to accounting standards, therefore allowing the numbers to add up. But there is also the prudent kind of balance. This means, among other things, that long-term debt is supported by ownership of long-lasting assets and there’s not too much debt. Then, it presents a good picture along with an income statement that tells a good story, especially when you put them side-by-side, looking at a few years together. And most importantly the business with its owner must have the income resources to assure repayment.

It is very common that small business owners have insufficient funds to buy the equipment, fixtures, inventory, or to pay the operational costs to run the company. Desperate owners reach for nontraditional sources for funding like personal credit cards, private loans or a growing group of “easy internet lenders.” These latter types, especially, may appear to be great funding sources in a tight situation, but these lenders are not right at all for supporting long-term assets or growth requiring permanent working capital. Once you dive in the easy internet pool it’s hard to swim out and retire high-priced debt unless you have high profit margins. So, count that out because if you had such good margins you probably wouldn’t have needed these lenders in the first place. Too many times I have seen borrowers accumulate loans from these quick-fix sources piled upon multiple credit cards to support financing needs that are really of a long-term nature. So the use of these sources is both risky and a mismatch against the financing needs of their businesses.

So, when you sit with a lender like CEDF or your bank to discuss funding for, say, a new piece of equipment or an expansion into the space next door, you should try to understand how your balance sheet and your income statement looks to the lender.  What are they looking for and what story does your paperwork tell them when it’s all put together? Does it suggest you have good balance in your use of debt and strong sources of repayment? Is it one that might result in a supportive decision or does it immediately evoke questions that will result in a rejection of your request?

While not all businesses fit into an idealized debt structure, just ask yourself a few questions:

  • Does my business have a debt structure (long term loans) that support long term assets, with short term assets (accounts receivable and inventory) supported by short term loans?
  • Are the book values on my balance sheet of those short term assets (accounts receivable and inventory) and long term assets (equipment, machinery, vehicles, furniture, fixtures and real estate) larger than the loans that they support? If they are not and you don’t have sufficient liquidity (cash and investments), your balance sheet is not “in balance” regardless of what the equity section tells the banker.
  • How does my banker view my debt service coverage ratio (DSCR)?

Here’s the quick definition of DSCR:

Business Annual Net Operating Income (less taxes, interest payments, depreciation and amortization) divided by the Current Year Debt Obligations (including principal and interest on existing and requested loans, loan fees and leases, if applicable).

Standards can vary with circumstances but a 1.25 ratio is an often used threshold for approving a loan. DSCR is a simple measure, but it can be complicated by other debt sources in the typically undercapitalized worlds of small business owners. Remember that lenders look to owners to guarantee repayment of the loans, so owners’ own personal debt levels matter greatly.

Here’s a terrific article that elaborates on many aspects of this important concept.

This article was originally published in CEDF’s stakeholder newsletter, The Advance.

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