Whether it’s investing in marketing, hiring salespeople, or paying back vendors, small businesses often need outside funds to grow. The most tried and true option for business owners is still visiting the bank and applying for a loan.
Even with all the financing options available today, banks still generally provide the best rates. However, the application process can take months of time and mounds of paperwork. And even after all that effort, there’s no guarantee of approval.
According to the U.S. Small Business Administration (SBA), small business loan approval rates in Q1 2015 were 22% for large banks, 50% for small banks, and 43% for credit unions. Most small businesses applying for loans are turned down by banks and credit unions. How can you maximize your chances at approval and get the best possible terms?
Understanding how the bank thinks about your application and crafting a compelling business plan will absolutely improve your chances of being approved for a loan. Here are 5 steps to help you walk into your bank meeting ready and prepared:
Know where you are going to use the money
As a lender, banks need to understand how their money is going to be used. As a borrower you need to make sure your business will generate enough cash to pay the lender back. Your use of funds should generate positive ROI for the business after netting out the loan’s interest expense. Know in detail what the money is for well before stepping foot inside the bank.
Gather the necessary documents
Beyond the business plan, there is a checklist of other items you will need in order to be approved. Financial statements, personal and business tax returns from the last 3 years, business credit report, bank account statements, articles of incorporation, operating agreement, commercial leases, and documents assessing collateral (more on that in Step 4).
Understand how the bank will assess your business
Bankers consider these metrics and several others before lending to your business. They need to make sure these ratios fall within their underwriting “box” – a range of acceptable ratios given to them by the bank.
- Loan to Value (LTV) = Total Debt / Value of Collateral. How much your assets “cover” the debt being loaned to you. Banks typically don’t like exceeding 80% LTV for small businesses. However, the type of collateral used to secure the loan will affect the bank’s acceptable ratio. For instance, unimproved real estate will earn a lower ratio than improved, occupied real estate. These ratios can vary greatly between banks and the ratio may also be influenced by criteria other than the collateral value. Strong financials and healthy cash flow may allow leeway for a higher LTV.
- Debt Service Coverage Ratio = Total Debt / Net Operating Income. Measures a business’ ability to generate adequate cash flow to cover their liabilities. A ratio greater than 1.0 is considered a very strong credit, but, fortunately many successful bank borrowers don’t have a ratio this high.
Prepare documents assessing value of collateral
Some business loans don’t require collateral. But loans at higher risk for default will often require substantial collateral. Strong business plans and financial statements can help you avoid putting up collateral up to a certain amount of debt. However, even with strong financials, too much debt in the eyes of the bank and you will need to back it up with collateral. Either way, it’s a good idea to prepare a collateral document that describes cost / value of personal or business property that will be used to secure a loan.
According to the SBA, Certificate of Deposits (CDs), will receive a value up to 100% and stocks & bonds up to 50%-90%. Equity in real estate, both personal and business, is also frequently used as collateral for business loans. Accounts receivable and inventory are also assets the bank will lend against, usually up to 75-80% of its value. KeyBank provides a good overview of their collateral criteria online.
Prepare a detailed business plan
Follow this general structure for a business plan. Keep your plan clear but with the necessary details. Remember, you’re pitching your business to a capital provider, it’s okay to be a little salesly in the document as long as it’s backed up by data and reasoning.
- Executive Summary – Keep this simple and clear. Briefly describe who you are, your business background, the nature of your business and how the loan will be used.
- Company Description – Describe the history of your business and summarize current activity and results. Describe your market, your customers, and your industry.
- Management Experience – How much experience and what qualifications do you and your team have?
- Organization and Management – How is your business structured? Who’s in charge and what are their titles?
- Services and Product Lines – What do you sell? Is it services, products, both? Do you have recurring revenue contracts or do you earn a onetime profit on every sale?
- Marketing and Sales Plan
- Set yourself apart from your competitors: Why do customers want to buy your product / service? Is there opportunity in a certain niche, location, etc?
- How do you acquire customers? Do you use search engine and social media advertising, inside sales, outside sales, referral partners, all of the above?
- Funding Request – How much funding do you need and what are you using it for? It’s good to familiarize yourself with the types of loans available as well. Coming in armed with that knowledge will make you sound like you’ve done your homework. As a result, you will be taken more seriously.
- Projected Financials – Have optimistic projections backed by data and reasoning. This is where you can really tell the story of your business. Be sure to show projected cash flow, not just revenue. Bankers care about cash, particularly if you have enough to cover their interest and amortization payments.
- Historical Financial Statements (3 years) – It’s best to have an accountant put these together, but understandably that can be expensive. Most current accounting software (i.e. Quickbooks, Xero, Freshbooks) will be able to put together financial statements using your bookkeeping entries. However, make sure your historical entries are accurate! The software is only using what you’ve inputted. You will lose credibility with a lender if you need to fix your financial first.
- P&L or Income Statement
- Cash Flow Statement
- Balance Sheet