By Alan Olsen
Whether you are a small or medium size business, the process of obtaining a loan is similar. Commercial lenders are interested in:
The purpose of the loan. With a seasonal loan, for example, the borrower is able to pay the loan back when inventories and receivables decline after a seasonal surge in business, and this pattern is typically repeated from year to year. It is generally easier to obtain than a term loan used to provide permanent working capital, so long as the increases in inventory and accounts receivable during the busy season are consistent with past experience.
Term loans, which are generally paid back from cash generated by net income, are a different story. Here you need a business plan and cash flow projections derived from realistic expectations. An example of how to develop realistic expectations of future revenue is to survey the customers to ascertain the probable orders they will place, and to evaluate them in relation to past orders, e.g., evaluate events that account for significant increases in future orders compared to the past. Taking the simplistic approach of assuming next year’s overall revenues will increase by, say, 10 percent will not do it.
Management continuity: The borrower needs to provide evidence that management strength is not dependent on one person. There must be capable management in the wings.
Lenders will also be concerned with:
1. A concentration of business with a small number of customers or a dependence on one product.
2. Large owner compensation and benefits that are unlikely to be reduced in response to a decline in business.
3. Questionable quality of accounts receivable as measured by aging and bad debts
4. Low quality of inventories as measured by turnover and obsolescence.
5. Potential need to replace equipment or upgrade it to remain competitive.
6. And of course the borrower’s integrity and past history.
In obtaining financing, there are some basic ideas you should be aware of:
1. The business activities should be separate from the personal activities of the owners. For example many entrepreneurs use their personal checking accounts for their business operations. It is incredible that business would commit such an obvious mistake. These are primarily very small businesses. But one in five do not keep these elements separate. The business should also have a distinct legal structure: a corporation or S corporation, LLC, or partnership. The choice of the business legal structure has significant risk and income tax effects.
2. There are a myriad of types of business loans. Both the lender and the CPA can be helpful in explaining them, and in guiding the borrower towards the most appropriate kind of loan for it’s circumstances.
3. CPAs can also help the borrower determine the cost of the loan, and to evaluate the implications of loan covenants such as prepayment penalties, requirements that limit owner withdrawals, and maintenance of minimum financial statement ratios such as total debt divided by net worth of the business.
Accounts receivable financing is popular with companies that do not have the financial strength to qualify for unsecured seasonal or term loans. Lenders who finance receivables (and sometimes inventories and equipment) use those assets as collateral for their loans and monitor them closely. Because the monitoring controls the amount of the loans outstanding in relation to the value of the collateral, loan covenants are sometimes not as strict.
Personal guarantees of the business owners are generally required for loans to private companies, and since the pledge of assets protects the lender, it also protects the owners. In cases where the lender, for whatever reason, does not closely monitor the collateral, it might be prudent for the company’s CPA to periodically examine the collateral to determine that its value exceeds the loan balance.