Why is it so difficult to get a bank loan for your small business these days?
The short answer is risk.
As someone who has worked in banking for many years and managed countless small business loan requests, I understand the mind of a lender. As such, I’m here to highlight exactly what bankers are looking for and to walk you through the best ways to convince them to lend you capital. But first, let’s start with the basics.
Why Is It So Hard to Get a Small Business Loan?
The lending business model is simple. Interest rates earned from the loan payments must be higher than the probability of the bank not getting paid back. For example, if the bank deems that there is a 20% chance they will not get their money back, they must lend you the money at 25% APR in order to protect their risk.
The problem is that 25% interest is considered usury in many states and is therefore illegal. To be able to lend to a small business at a more reasonable rate of 6% to 9%, the bank must be at least 95% sure that the loan will not default. Now do you see why it’s so difficult for small businesses to get loans?
While it may feel impossible, the fact is that some small businesses do receive bank loans. So what’s their secret? How does the bank achieve 95% certainty?
The banks arrive at this number by measuring different elements that contribute to default risk. Their goal is to make sure all signs point to the business succeeding and generating a reliable source of revenue.
The Lender’s Checklist: 10 Things They’re Looking For
There are 10 common areas of focus that banks measure to determine default risk:
1. The industry the business belongs to. Although only 50% of businesses make it past their first five years of operation, this failure rate varies greatly by industry. For example, hospitals and doctor’s offices have a much higher survival rate than restaurants or retail stores.
2. Years in business. As businesses mature, they get better at what they do. They increase their market share, build a loyal customer base and gain a reputation in the market. Survival rates in businesses increase exponentially with time; a business with several years of experience signifies a lower default risk.
3. Financial ratios, such as profitability. Does the business have (and will it continue to have) enough profits to be able to not only pay the loan back, but the interest as well?
Lenders also look at solvency, or “cash flow.” Solvency represents the business’ ability to use its current liquid assets to pay for their current liabilities. The term liquidity refers to collateral (for example, a retail space) that the bank could easily liquidate (sell) if the business stops paying. If the business doesn’t have any collateral, then the lender looks at the value of all of the business assets, including things like equipment or inventory.
4. Business model. Is the current business model destined to survive fluctuations in economic, social or political environments? Is there a sound strategy in place to mitigate the potential risk of changing market conditions?
5. Credit history. Does the business have positive credit history with their vendors? With other banks? Do the owners of the business have good personal credit? Because many small businesses do not have extensive enough credit history, the owner’s credit plays an important role.
6. Personal guarantee. Do the business owners or guarantors of the loans believe in the business strongly enough to be personally responsible for repaying the loan even if the business fails?
7. Lawsuits, liens and tax liability. It is important for the bank to be sure that there aren’t any outstanding liens against the business’ assets and/or current or potential lawsuits that can put the business at financial risk.
Especially when it comes to IRS liability, the banks want to make sure there isn’t a significant amount of taxes due, because the IRS is incredibly efficient at collecting their money before the bank gets a chance to collect payment on their loan.
8. Owner’s equity. The bank wants to see that the owner has “skin in the game” and is willing to risk his or her own capital on the business, not just capital from their bank loans. If the business has loans from other banks, the lender also considers total current debt. The business cannot already owe substantial amounts of money to other banks or third parties because it makes it harder to collect.
9. Loan purpose or “Use of Funds.” To put it simply, banks want to make sure that the loan request “makes sense.” For example, if the business is going to borrow in order to purchase expensive equipment that will last five to seven years, then a five-year loan makes sense. However, if the business needs short-term cash to fund their operation because most of their clients take 30 to 60 days to pay for services, then a line of credit makes more sense than a loan.
10. Receivable concentration. This is essentially measuring the concentration versus the diversification of a business’ revenue streams. There are pros and cons to both of these.
A business that sells 80% of their goods to Walmart, for example, may be deemed to have a high concentration risk. However, the average lender might also conclude that there is a relatively low risk of failure since they are selling to one of the largest and most successful retailers in the U.S.
But no matter how stable a company seems, there is always risk. Consider the mindset towards companies that once sold almost exclusively to General Motors. When GM defaulted, most of these once-stable businesses had to shut down. Diversification may be harder for a small business to juggle, but multiple sources of income can also provide greater security if one revenue stream runs dry.
The Banking Relationship
Apart from the aforementioned big 10, the bank also looks at your banking relationship. Banks prefer to lend to businesses they have had a long-term relationship with. Banks can tell a lot about a business by looking into their checking accounts, such as:
- Consistency of client deposits
- How many of their checks bounce
Signs like these are huge indicators of how finances are managed in the business and how much cash flow they have consistently available.
Finally, remember that the lenders will probably ask for the following information, so make sure they are properly prepared and reflect your financial reliability:
- Financial statements
- Credit score
- Tax returns
- Bank statements
If you have any caveats or blips on these financial records, be prepared with a solid explanation.
Helpful Tips for Securing That Sweet Loan
In order to qualify for a loan when they need it most, entrepreneurs must build a strategy from the very beginning around being “lendable.” In my experience, small businesses with high success rates in acquiring bank loans tend to do the following:
- Work with their CPA from the beginning to lay a proper foundation and to bring stability to their tax and financial reporting strategies
- Work with a bank that is industry-friendly. So if you are in the farming business, it is best to work with a bank that typically lends to agricultural businesses.
- Be certain that you’re properly insured. What will happen if a natural disaster strikes, a worker gets injured or the business owner gets seriously sick? If you insure against the risks that are most relevant to your business, you will lower your default risk and increase your chances of getting a loan.
- Build a relationship of good standing with the bank. Open a checking account and a credit card in the desired bank, then never miss a credit card payment or bounce a check.
- Build a strong relationship with your banker. The banker can be your biggest ally. If the banker knows you, knows your business operations and knows that you have good employees and a stable customer base, they will be more likely to go the extra mile and guide you through the application process.
In next week’s article, I will discuss the presentation of financial statements that banks look at to determine the risks involved with lending to businesses, and I’ll break down each individual element within those financial statements to hopefully increase your chances of landing a bank loan.