Know the 4 Cs of commercial banking before applying for a business loan
The iron is hot for businesses looking to grow in the next year, thanks to continuing economic recovery and low interest rates. These low rates put bank loans for equipment, real estate, working capital, and other needs within reach for more companies.
In addition to being affordable, loans are also becoming more available as banks increase their lending. The Wall Street Journal reports large banks are awarding more loans to businesses, and smaller banks are similarly making new loans.
But even in this improving lending environment, banks are generally cautious when evaluating clients for potential loans, particularly in light of tighter regulations and oversight. By understanding how commercial loan applications are reviewed, business owners can put their best foot forward.
If you’ve ever shopped for an engagement ring, you probably learned the “four Cs” of diamonds (cut, clarity, color, and carat). Commercial lending also has a set of four Cs: cash flow, collateral, credit, and character. Business owners seeking bank financing can benefit from understanding each of these.
Lenders are primarily concerned with how a loan will be repaid. While collateral is an important part of any loan, the seizure and liquidation of an asset creates additional headaches for the lender and borrower alike. For this reason, lenders like to see a historic trend of profits in excess of potential monthly payments. Generally lenders want to allow a cushion of 25% of the payment — so if the monthly payment for your new facility is $1,000, you should have $1,250 available in your budget.
Determining cash flow can be complicated when considering inventory, receivables, and accounts payable. These items count toward your overall assets but are weighed differently than pure profits. An analyst or someone from the credit department at your chosen lender will usually examine your financial information to help you determine a feasible payment schedule.
When applying for a loan to purchase a physical asset like a refrigeration system or vehicle, the item will generally serve as collateral; if the loan is not repaid, the bank can reclaim the property. Applying for a line of credit or a loan for expansion of nonphysical assets will require you to offer property you or your business own as collateral.
Due to depreciation and potential collection-related legal fees, collateral is not an ideal repayment option for lenders. Most will only offer loans that equal around 80% of the value of the property offered as collateral. Higher ratios are possible, but many banks are wary of the risk and additional regulations imposed by the FDIC. You should anticipate an upfront cost of at least 20% of the asset you hope to purchase.
Your credit score is the most telling information we can examine when considering you for a loan. Both your personal and business credit will be considered, with a focus on the timeliness of repayments and collection of receivables. Damaging items like charge-offs or liens hurt the chances of obtaining a commercial loan.
Banks are looking for applicants who demonstrate a history of responsible money management, and your credit score will factor heavily in the rates you are offered, and may even prevent you from obtaining a loan. A score of 700 or above is ideal, and anything below 630 will likely raise too many red flags.
Establishing and maintaining good credit can be a confusing process, fraught with misconceptions. The most common misconceptions relate to the following topics:
- Checking your credit report: Monitoring your score through one of the credit reporting agencies is a “soft inquiry” that has no effect on the score, and it should be done regularly. Applications for new credit will prompt a “hard inquiry,” which does show up on your report and can impact your score if done frequently.
- What determines your score: Your FICO credit score is determined by your payment history (35%), amounts owed (30%), length of credit history (15%), types of credit used (10%), and new credit (10%). Although income and employment have no impact on your score, your lender will want information on both.
- Closing unused credit cards: Closing an unused card can actually have a negative impact, because your score is partially determined by your ratio of debt to available credit. Instead aim to keep all of your balances below 50% of the applicable limit, and only apply for new credit when you need it.
- Co-signing a loan: Until a first payment is made, co-signing a loan can temporarily drop your score. A missed payment will negatively impact your score like any other loan and can affect you for up to 10 years.
- Working with a credit counselor: Working with a credit counselor to establish a path back to good credit will not directly affect your score, but some financial recommendations might. Loan modifications, charge-offs, and other debt restructuring can have a significant effect on your score.
Making on-time payments over several years is the best way to raise your score. While paying down debt helps your overall creditworthiness, even resolved negative items will remain on your report for seven years. Fortunately, nothing remains on your credit report forever, so establishing good habits today will eventually help eclipse any negative factors.
Although deficiencies in the other categories will greatly reduce the likelihood of securing a loan, character can help turn a “maybe” into a “yes.” Your loan application will be considered by a loan officer or review team, and they will scrutinize your relationship to your business and the ethics of your actions.
If you have a demonstrated history of fulfilling obligations and working with creditors, you will be a more appealing candidate, even if the recession left a few black marks on your credit report. Those working in commercial lending tend to be inquisitive and shrewd, so presenting yourself in a professional and well-informed manner will provide positive context as they consider the hard numbers of your application.
Finally, be specific when putting together a loan proposal. You may want to “expand your office and upgrade your manufacturing facilities,” but your lender will want to know how many square feet you plan to purchase or build and see a precise list of equipment you would like to buy. Always demonstrate purpose when applying for a loan, and include a well-researched forecast of how additional funds will impact your business and profits.
Partnerships are built on trust, and banks will use both financial and personal information when deciding whether to accept your courtship. If you demonstrate an ability to handle personal and business credit, you and your lender can be on your way to a partnership that helps fuel your growth.
Stephen Machotka is market president at Wisconsin Bank & Trust.
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