Business borrowers aren’t just facing higher interest rates today. The terms of new loans have also become more restrictive. Nearly a quarter of senior loan officers reported tighter standards for commercial and industrial loans in the Federal Reserve’s second-quarter survey on bank lending practices.
As banks rein in their lending practices, it’s important for business owners to put their best foot forward when they apply for credit. Here’s how to position your business in the best possible light on a loan application and negotiate favorable loan terms.
Learn the 3 Cs of Lending
Underwriters will assess the following three key factors when deciding whether to approve or deny your loan application:
1. Character. The strength of the management team — its skills, reputation, training and experience — is a key indicator of whether a business loan will be repaid. Banks also look at the company’s track record with creditors, including its credit score and trade references from key suppliers. The latter tend to be submitted by businesses without established credit histories and those that deal with smaller suppliers that don’t report to credit agencies.
2. Capacity. Underwriters want to know how you’ll use the loan proceeds to increase cash flow enough to make loan payments by the maturity date. To determine your ability to repay the loan, lenders will evaluate past and projected financial statements, as well as your business plan.
3. Collateral. This term refers to the assets pledged in the event that you don’t generate enough incremental cash flow to repay the loan. It’s a lender’s back-up plan in case your financial projections fall short. Examples of collateral include real estate, savings, stock, inventory and equipment.
Additionally, an owner’s personal credit will be factored into the lending decision for a private business, and the bank will likely require a personal guarantee from the owners. So, expect to share personal financial details and put your personal assets on the line to secure the debt, even if your business is incorporated.
Fed Survey Findings
The top tightening measure banks currently are employing is charging premiums on high-risk loans. That measure was mentioned by 20% of respondents to the Federal Reserve’s July 2022 Senior Loan Officer Opinion Survey on Bank Lending Practices. Other tightening measures include raising the cost of credit lines, widening the spread over the bank’s cost of funds and increasing collateral requirements.
In addition, the survey identified the following key reasons for implementing more restrictive lending practices:
- A more uncertain economic outlook,
- A reduced tolerance for risk,
- Deteriorating industry-specific problems for the borrower,
- Reduced liquidity in secondary loan markets, and
- Increased concerns about the effects of legislative changes, supervisory actions or changes in accounting standards.
Loans officers expect even greater volatility in the second half of 2022. They project borrowers’ debt-servicing capacities could worsen as inflation persists and collateral values fall. However, demand for commercial and industrial loans is expected to remain high, despite rising interest rates and tighter credit practices.
Loan Application Basics
If you need money to grow or maintain your business, it’s important to understand how the loan application process works. It starts with four basic questions:
- How much money do you want?
- How do you plan to use the loan proceeds?
- When do you need the funds?
- How soon can you repay the loan?
Your loan officer will also ask about your company’s previous sources of financing. So, you’ll need to explain your business and how it’s been financed to date. This includes your personal cash infusions, forgone salaries and sweat equity, as well as any equity contributions from friends, family members and outside investors.
Banks generally offer two types of financing:
1. Lines of credit. A line of credit is primarily used to meet working capital fluctuations. It’s generally considered short term, and banks may expect repayment within the next year. In practice, however, most businesses keep their revolving credit lines open for many years, occasionally drawing and repaying funds based on operating cash flow.
2. Asset-based loans. These loans are for specific items. They usually fund equipment purchases or plant expansions. With asset-based loans, the length of the loan is usually tied to the life of the asset that’s financed, and that asset is usually pledged as collateral for the loan. Banks generally don’t allow business owners to finance 100% of an asset purchase. Instead, you’ll probably be expected to contribute a reasonable down payment.
When applying for a loan, lenders want serious borrowers who are invested in their businesses and aware of their financial condition and performance. Don’t go into your lender’s office empty-handed. Instead, bring a comprehensive loan package that includes:
- A narrative “statement of purpose,”
- Three years of business financial statements (including balance sheets, income statements and statements of cash flow), if available,
- Three years of business tax returns, if available,
- Personal financial statements and tax returns for all owners,
- Appraisals for assets pledged as collateral,
- Your business plan, and
- Prospective financial statements.
Loan officers have seen all kinds of business plans and financial projections — and they know how to critically evaluate the underlying assumptions. Where possible, support your assumptions with market data and research. It’s important to be realistic about your strengths and market opportunities, while being forthcoming about your weaknesses and potential threats to your growth.
If your lender thinks you’ll make a viable borrower, your application will be given to the bank’s underwriting committee. Underwriters will have greater confidence in your historic and prospective financial statements if they’re prepared by a CPA and conform to U.S. Generally Accepted Accounting Principles (GAAP).
Also, remember that this list is just a starting point. Underwriters may ask for additional information, such as interim financial statements, lease agreements and marketing brochures.
Underwriters don’t approve every loan application, especially when the demand for new loans is high. But don’t give up if one bank turns you down. Ask why the application was denied, fix the problem and try again. Also don’t be afraid to shop around. Viable borrowers could receive multiple offers, allowing them to pick the option with the most favorable terms.
Working with your financial advisors can increase your chances of getting approved and help you negotiate the best possible loan terms. They’re familiar with the loan application process and can help you compile a comprehensive loan package, as well as prepare realistic business plans and prospective financial statements.