By Stephen Perl, MBA, MS
No matter the size or time in business, getting a loan can be completed for most businesses by understanding the various financial products that are readily available and who offers the financial products in the market.
Knowing one’s business credit and its principle’s credit is the first step before searching for a line of credit. One does not have to be an expert in credit, but they will have to know if their credit in relative terms in poor, medium, better than average or excellent from the business and personal standpoint so they can determine where they are most likely to get financing. One can think of the world of finance as having a natural order and a fixed credit structure. The question is how to understand this order as most business owners do not have intimate knowledge of this structure.
Evaluate the principle ownership’s personal credit. Even though one immediately assumes that a business should stand on its own credit, a business owner of a privately owned business with sales between $1 to $100 million USD are normally subject to a “Personal Guarantee”. This should not be taken as a personal offense, but as a typical standard of care that almost all lending institutions are required to have in their underwriting process. The ownership’s personal credit will usually set the tone for the type of lending institution that the company will qualify for. If the ownership has perfect credit then they are typically headed for a traditional cash-flow based loan issued by a bank. If not, then they are headed for an asset based loan that can be issued by banks or various lenders.
Evaluate the businesses credit. Evaluating a company’s credit can be quite intensive, but there are certain features a business owner can easily look at to understand the quality of loan they will represent to the lender. Of course, the size of the loan will also be a factor in the lender’s decision making process as well. In this process, an owner must have a balance sheet that it maintains accurately to find the necessary information to evaluate its credit worthiness. The key indicators are current assets such as cash in the bank like inventory, accounts receivable (with an aging breakdown), and on the other side of the balance sheet, loans like accounts payable and long term debt are important, and finally, the shareholder equity is key. Loans and payables tell the bank about the current leverage and how your company is doing with its supplier obligations. Shareholder equity is important when determining the maximum size of the loan. Typically, lenders will not provide leverage of more than 3 to 5 times the actual equity on the business’ books. For example, if a company has a $1 million USD in equity then the loan would be equivalent to a maximum of 3 to 5 times the equity or $3 to $5 million USD.
Knowing Steps 1 & 2, a business owner can understand their current position and were they fit in the below fixed credit structure of financial products typically used by small to medium sized businesses.
The fixed credit structure in the U.S. does have a bit of flexibility but for the most part is very strict. The perfect company that banks are willing to fund typically do not need money that urgently. As a standard practice by banks in the U.S., a company with at least 3 years of financial statements (usually reviewed statements will be required which are one step below audited CPA statements) and at least 3 years of profitable business tax returns are candidates that should traditional apply for a bank loan. Now, the owner’s personal credit will be important in this process and the owner’s ability to come up with a secondary source of repayment such a property with a lot of equity. If this type of loan can be obtained then it is best, but if the business needs more money than 1 to 3 times its equity, then it will probably need to look for a more leveraged financial product.
The SBA Loans that banks provide also provide some flexibility as they are known to be easier to qualify, but frankly since the bank’s are underwriting the loans, they are quite strict as well. SBA is defined as the Small Business Administration loan that the US government provides guarantees to encourage banks to be more lenient. SBA loans come in 2 flavors, the 7A and the 504. The 504 Loan is a loan package designed to finance the real-estate a business owns and typically is used for buying a business’ head office or factory if the business is occupying more than 50% of the real-estate. The 7A Loan is a cash-flow based loan based on the business’ financials and typically as difficult to qualify for as a regular bank lending product because the bank underwrites all loans with usually the same credit policies.
Often fast growing businesses are strong in many categories but they lack the +3 years of financial history due to fast growth and re-investment needs. These companies should not be dis-heartened as a traditional bank will most likely play a key role in their future, but they must focus on the right lender by understanding the natural order in the market.
Factoring and Asset based lending are great ways for a fast growing company to have confidence that they will have cash-flow and the funds to continue their growth / acquisition of new customers. Factoring is defined as discounting invoices and using the accelerated payments as working capital to maintain sales momentum. There are all shades of factoring and many companies providing factoring are not even licensed lenders as it is not required. It is best to find a licensed commercial bank lender so that you can access a receivable line of credit. A receivable line of credit and factoring are similar but the costs are typically very different where a factoring line will be more expensive. A factoring company typically charges fees on all invoices whether financed or not, but on a more traditional receivable line, a business is only paying of the invoices used to provide funding. The bottom line is that there should only be one or two fees with a receivable line of credit, and the rates should be a bit higher than a regular bank loan because there is less collateral and a high leverage on this type of financing. The higher rates for receivable financing are typically warranted also because the personal credit of the owner is not very strong and there is little to no secondary collateral in case there is a problem and repayment is required. A receivable line of credit also has many advantages as it is much more flexible and more easily maintained than a traditional bank line of credit as there are no review or audited statements required on a yearly basis.
Understanding that there is a financial order in the financing market and searching for loans that are best suited for your company with the right lenders will save you time and frustration.
By Stephen Perl, CEO/CFO
1st PMF Bancorp – national commercial lender.
Mr. Perl has been lending for 2 decades and speaks at many financial conferences in U.S. and in China on Asset Based lending and trade finance. He is a Director for the Commercial Finance Association and an Advisor to Los Angeles City Mayor’s Small Business Lending Board.
Questions on article: Stephen@PMFbancorp.com