Myths and misconceptions about the reason banks decline loans and the rate at which this happens are as common today as ever. As a banker, it’s my goal to bring clarity to the process, and explain what it takes for a business to get a loan and why a loan application may be declined.
Let me share a few credit basics small business owners should know before applying for a loan that may make the loan review process easier to understand.
For a banker, evaluating a credit application means reviewing the five C’s of credit: credit history, collateral, capital, conditions and capacity. You may have heard of these five general areas that help determine whether a business loan will be approved. Yet here are five things you may not know about the five C’s:
Did you know both business and personal credit history are important when pursuing business credit, particularly smaller loans? Looking at credit history helps us answer the question: How has the borrower handled credit obligations? Both business and personal credit are relevant. On the personal side, a lender will look at the business owner’s history of credit management including FICO score and details of their credit record. A lender also will want to know whether the business applying for credit has paid suppliers and other business obligations in a timely manner, including those to other financial institutions.
That’s why a deep tenured business and personal credit and deposit relationship with a bank can make a difference. When you pursue a loan at a bank that knows you, a banker can see your current balances relative to 12-month averages and annual sales – and can better determine whether your business has strong enough cash flow for new credit. And a banker can see if a business avoids overdrafts. It helps tell the lender whether the business is credit-ready.
Did you know that when it comes to "capital," a banker wants to see that an owner has a significant investment of personal capital in a business? When a lender sees the owner invest money in the business, it shows that the business owner is committed to succeeding. What’s more, a business owner with assets that can be converted into cash in case of a sudden downturn in revenue will be better able to operate his or her business and repay debt.
A lender wants to see that the assets of the business sufficiently exceed its liabilities, and to understand how quickly and easily those assets can be turned into cash.
Did you know that "conditions" are both internal and external factors that affect the ability of a business to repay a loan, as well as the intended use of the loan? For example, on the external side, conditions can be economic factors, such as the strength of the housing market for businesses that are tied closely to this important sector. In today’s improving economy, conditions in many industry segments are getting better, giving banks confidence in lending to those segments.
On the internal side, conditions include the borrower’s business experience and knowledge. A lender will ask: Is the owner someone who has extensive experience in the industry or relatively new? In some cases, business references and education are personal factors that can affect conditions.Both internal and external conditions can be important indicators of a business’ ability to survive and thrive, and therefore its ability to repay its credit obligations.
Did you know that "collateral," when it’s required, is a secondary source of repayment to a lender in case of default? Collateral can include personal assets – like investments and CDs – and business assets – such as real estate, inventory, equipment and accounts receivable.
Collateral doesn’t replace good payment history or showing your ability to handle the proposed debt level. Nobody wins when a bank turns to the final option for repayment of liquidating collateral. In fact, it often results in a loss to the financial institution – it’s absolutely the last thing a bank wants to do. A healthy business that’s using credit the right way is a win for the business, for the bank and for the community.
Did you know that a lender looks at cash flow and debt to determine whether a business has the "capacity" to handle new credit? Before extending a loan, a banker wants to make sure a business has the ability to repay a loan given its other pre-existing loan or payment obligations. Typically lenders look for a business seeking credit to have a debt-to-income ratio of no more than 40 to 50 percent, depending on its credit score.
Profitability and cash flow are essential components of capacity. A business must have enough positive cash flow to meet both short-term and long-term commitments. A lender will carefully consider the cash flow of a business to gauge the probability of repayment.
Again, a long-term relationship with a bank can help, since the banker knows the customer, and is able to see deposit inflows to have a good idea of business income and sales.
When you understand the five C’s of credit, you have pretty good idea what it takes to get a business loan. Small business approval rates are increasing, and the reason should come as no surprise. Healthier businesses, better balance sheets, and stronger revenues mean more businesses today qualify for credit.
Now, it’s up to all of us in banking to keep spreading the word about how more small businesses can get credit-ready before pursuing a loan.
To help more small businesses achieve financial success, Wells Fargo recently introduced Wells Fargo Works for Small BusinessSM – a broad initiative to deliver resources, guidance and services for business owners. For more information, visit: WellsFargoWorks.com.