What Do Banks Look for in a Business Before Lending Money?
written by: N Nayab•edited by: Jean Scheid•updated: 7/12/2011
All businesses need cash to finance investments and fund operations before generating revenues. Bank loans are a major source of funding, but banks have strict guidelines and requirements for lending money to businesses.
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The major types of business loans offered by banks are:
Short-term loans with less than a year’s duration, to finance working capital, accounts receivables, and lines of credit.
Long-term loans, with maturity period usually between one and seven years, or even more, for capital investments such as equipment purchases, a commercial mortgage, furniture, vehicles, and other similar purposes.
The adage goes “A banker is a person who lends money after you convince them that you do not need it." While this may be stretching the case, banks do have strict guidelines on reserve funds and collateral to secure their loans if the investments do not bear fruit. Banks primarily consider the five C’s: character, capacity, collateral, conditions and capital before deciding whether to extend loans to a business.
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Collateral is the assets a business owner pledges to secure a loan. It may take the form of the business owner’s personal property, a long-term bond, cash value of insurance policies, or anything else other than the actual business assets for which the loan is availed, which anyway remains pledged with the bank. Most banks insist on collateral security to protect their loan in the eventuality of the investment not bearing fruit, or as an insurance against non-repayment. The absence of collateral could result in the business owner walking off, and the assets of the business pledged with the bank not sufficient to cover the loan repayment. Banks reason that business owners remain more motivated and committed when personal assets remain at stake as collateral.
Banks look at whether the proposed collateral is marketable, is free of legal hassles, and has adequate insurance before accepting collateral. In the past, banks accepted a co-signer or a guarantor as collateral for small loans, but difficulty in recoveries from such co-signers make most banks refuse this option and insist on real collateral.
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Character refers to the track record or background of the business and / or business owner. Banks try to convince themselves that the borrower will repay before approving the loan.
For existing businesses, banks refer to financial documents such as accounts and balance sheets for information on capitalization, reserves, turnover, profits, profitability ratios, value of capital assets after depreciation, and related information to ascertain the financial health and stability of the company. The banks also consider the managerial and technical expertise available with the business, which would allow them to put the loan money to good use.
For start-ups and small businesses, banks primarily look at the character of the entrepreneur or business owner. In such cases individual credit ratings, track records in making money, experience, expertise, managerial ability, exposure to the proposed investment, and other factors come into consideration. Late payments, delinquent accounts, high debts relative to income and other factors may adversely affects an individual’s credit score (FICO score) and become a barrier to availing a business loan. The business owner having a long relationship with the bank also helps.
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Bank loans depend on the size of the investment, and the proportion of the loan to the total investment. When business owners commit a sizable proportion of funds from personal sources, banks feel confident to commit the remaining portion. Business owners looking at banks as the major source of funding may make banks doubt the owner’s commitment to the venture.
Entrepreneurs without adequate personal assets may consider opting to raise capital through equity, partnerships, or other methods, or even opt for methods such as leasing machinery instead of purchasing to reduce the start-up investment before approaching banks to bridge the deficit. They may also approach the Small Business Association, and Small Business Investment Companies for loan assistance if commercial banks remain reluctant to sanction loans.
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Approval of business loans depends on the ability to repay the loan from the proceeds of the investment. The business owner needs to prove the business would generate revenues to pay the bank loan, and that liquidating the assets would allow repayment of the loan in the eventuality of the business sinking.
Banks refer to financial statements and project reports to make such decisions. A good project report makes explicit the purposes of the loan and demonstrates how the business would use the loan to generate sufficient cash flows to fund operations, repay the loan, and still make a profit. Most banks have experience with other companies to determine whether the projections made in such reports are realistic. One positive factor is confirmed future orders.
The collateral notwithstanding, banks also consider the ability of the business owner to pay loan installments even if the business does not generate positive cash flow. Business owners’ alternative source of income, and easily liquid investments such as equity, may help.
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Banks consider factors such as external environment, industry outlook, macro level trends, state of the economy, government’s monetary and fiscal regulations, impact of natural events such as hurricanes, extent of competition and other factors over which the business owner has no control. Banks also consider some factors such as viability of the proposed location of the business, under some control of the business owner.
Banks considering such conditions help business owners, for denial of loan owing to unfavorable conditions reveal the risky nature of the investment, and approval of the loan confirms the strength of the proposal. Banks, however, may also take decisions based on how the business owner proposes to handle such eventualities. A good project report needs to undertake a thorough SWOT analysis, and include contingency plans and a risk management approach in detail.
At times, regardless of any other factor, the bank simply may have low capitalization and may not be in a position to extend fresh loans to anyone, regardless of the attractiveness of the proposal. The U.S. banking regulators require banks to hold at least eight percent of their “risk-based" assets as reserves.
Banks adopt requirements for lending money to businesses, for unlike venture capitalists who share both profits and losses, they take a fixed and usually low return, and in return, do not entertain much risk.
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University of Maine. “Capital Sources for Your Business." http://umaine.edu/publications/3008e/. Retrieved July 09, 2011.
Entreprenueral Institute. "Barriers to Bank Lending." http://www.gdrc.org/icm/micro/bank-barrier.html. Retrieved July 09, 2011.
Cebenoyan, A. Sinan & Strahan, Philip, E. "Risk Management, Capital Structure and Lending at Banks." http://fic.wharton.upenn.edu/fic/papers/02/0209.pdf. Retrieved July 09, 2011.
"Bank Loans for Small Businesses." http://smallbusiness.dnb.com/business-finance/business-loans/2542-1.html. Retrieved JUly 09, 2011.