Ravi Chandran
To obtain bank financing for your business, the relationship between your company and the banker should be open and honest. If this is not the case, perhaps it is time to consider a different bank.
By: Phoenix Lee/
When trying to obtain bank financing, do not make a decision based upon a particular loan officer, because this relationship can change if the loan officer is replaced. Therefore, consider both the relationship with the loan officer and the relationship with the bank. It is also possible for your business to grow to the extent it does not fit the capacity of its existing bank. If this happens, consider establishing a new relationship with a larger bank that can handle your company’s future needs.
The first step in trying to obtain bank financing for an expanding business should be to understand and meet the exact requirements and concerns of the bank.
To avoid risks and make safe investments, bankers primarily base their decisions on the collateral and equity positions. Other concerns of a banker include cash flow, profitability and management ability.
Collateral is important when you are trying to obtain bank financing
Debt can be either secured by collateral or covered by a firm’s assets. A bank considers collateral the final alternative (last resort) for collecting money if payments are not made on loan principal. Often in a business start-up, the initial balance sheet will show an adequate collateral position; however, six months to a year later, the balance sheet may show a decreased collateral position.
It is also possible to lose collateral in the first years of a business by borrowing money and then gradually using that money to pay for expenses (such as utility bills and marketing costs) that do not result in asset appreciation. When a bank forecloses on a failing business, it is often unable to recover the full amount the owner paid for the assets, because of depreciation and the nature of a force sale. As a result, foreclosure leaves the banker with assets worth less than the dollar value indicated on your balance sheet.
For these reasons, you can understand why it is easier to borrow money to buy fixed assets (such as inventory, equipment, buildings and accounts receivable) than it is to borrow money for marketing expenses or general operating costs.
Equity is useful when trying to obtain bank financing
Bankers also review the current and projected equity position of a business. Equity is listed as owner’s equity or a combination of capital and retained earnings. The owner’s equity is usually calculated by subtracting all liabilities from all assets. The important aspect of equity is not so much the dollar amount but the ratio of equity to assets or debt.
A growing business usually shows an equity position of 30 to 50 percent in relation to total assets, i.e., the owners own 30 to 50 percent of the company. Initially, such an equity position may be adequate, but it may become inadequate when additional money is needed for growth. Because of the need to maintain the equity ratio in its relative position, additional equity may need to be brought into the company.
For example, suppose a company’s total assets are $100,000; total debt, $70,000; and owner’s equity, $30,000. The equity-to-assets ratio is 30 percent. For this business to grow to an asset level of $200,000, the owner needs to provide an additional $30,000 of equity and then borrow another $70,000 (debt). Ways to bring equity into a business include
- Venture capital funds
- State and federal financing programs
- Private investment
- Owner’s personal investment
An alternative to obtaining equity is to wait and reinvest the business’s profits to finance the growth.
Cash Flow Projections
For any business growth cycle, cash flow projections that compare cash receipts and cash expenses should be completed. Bankers realize that bank loans are paid from the business’s cash flow, so you must convince them that there is adequate potential to repay the loan.
Income (Profit and Loss) Projection Statement
The profit and loss statement, more commonly known as an income statement, reflects the dynamic changes that occur over time between two balance sheets. It reflects the company’s operation as a result of management’s efforts to generate a profit. The income statement matches all revenues with corresponding expenses for a specific period of time and reports the company’s ability to generate profits (excess of revenues over expenses).
Income projections should indicate when profitability will occur. Even though profit and cash flow can be unrelated, the possibility of having an adequate cash flow definitely increases when a projected income statement shows a profit. Bankers generally assume that a loan can be repaid if the business is profitable. The banker’s concern in this process is, Where is the profit going? If the profit is being reinvested into expansion activities, such as increasing inventory or marketing expenses, the banker’s concern is whether or not loan payments can still be made.
Management Ability is key when you are trying to obtain bank financing
A growing business usually has the advantage over a new business of having records on past performance that reflect the owner’s management ability. Management and the organization must be flexible to allow for growth and change. Consider the following question: If growth occurs, will management be able to handle the new situation? Your answer should help you determine whether you will need to hire additional managers or develop current management skills.
Simply developing and implementing a strategic plan to obtain additional funding will test management’s ability to plan and handle growth. The activities involved in obtaining needed financing are in themselves a new challenge to management. Management weaknesses should be addressed as a part of the growth process.
Personal Financial Statement
Usually banks will require personal financial statements from all owners. Personal financial statements are the balance sheets of the business’s owners. They are an important part of a business’s financial package because:
- they verify the company financial statements;
- they identify hidden company liability or equity; and
- they reveal other activities vying for an owner’s attention.
Strong company financial statements are generally reflected in strong personal financial statements; therefore, the stronger an owner’s financial statements, the better his or her chances of obtaining the loan.
Wealth accumulated on a personal balance sheet is an informal method of judging an owner’s ability to obtain, manage and keep money. Personal financial statements should not include existing business activities; these figures should be supplied separately. As indicated above, the banker is looking at potential collateral and adequate equity.
Market Value Balance Sheet and the ease to obtain bank financing
One of the problems in a growing business is that the existing equity or collateral position can be artificially low because of accelerated depreciation. Using accelerated depreciation results in a bookvalue balance sheet that has less equity or collateral than a market-value balance sheet. The former shows assets at their depreciated value whereas the latter shows the assets at their current market value. Thus it may be important to provide a banker with a market-value balance sheet.
A typical way to develop a market-value balance sheet is to present your current book-value balance sheet with an additional column for the market value. At the bottom of this balance sheet explain each column. Documentation of market value can be provided through appraisals or advertisements that include prices on similar equipment or assets. The market-value balance sheet usually increases the equity dollar amounts and the equity-to-assets ratio. This should result in a banker’s willingness to loan a larger amount for growth activities.
Business Plan
A business plan is the blueprint or road map for the owners to successfully carry out growth in a business. This plan communicates the intentions of the owner to others and can be used to obtain financing. The content of the business plan is determined by the planning process itself, and includes research documenting growth potential. Business plans include:
- Cash flow projections
- Income statements and balance sheets with a detailed narrative of how growth must be attained
- Justification for numbers used in financial statements
