Loans

Independent investors in the business (if any) have yet another set of motives: they want to pay as little as possible for each share and see the value of that share grow. Investors like to "leverage" their investment by seeing it matched by borrowing. Since the borrowed money is used on their behalf, the more borrowing they can leverage the better. But, here too, constraints set it. Under current law the creditors of a business are first in line when the business fails. If the company is highly leveraged, investors are likely to lose their entire investment. Thus leverage is good—but it must be kept in line.

The lender, finally, is moved by a desire to earn money by lending it safely. Sources of large amounts of cash (banks, credit unions, insurance companies) are typically restrained by law and prudence from speculative investment of the money they hold in trust for others. They are conservative by their very structure and aim at predictable earnings by the safest possible means. Lenders ideally want secured loans at high interest rates, the latter kept low by competitive forces. They prefer to lend to the financially strongest possible borrowers; if competitive pressures force them to lend to weaker customers, they hedge the risks by charging more. From the lender's point of view, a financially strong borrower is one who has invested much and therefore has a great stake in the business's success; the business will also have a long, successful, and steady history of operations, and will offer ample collateral.

A small start-up with a brief history of mild success is thus in a relatively weak bargaining position and must make a very strong case before a favorable action by a potential lender is assured.

QUALIFYING FOR A LOAN

The three main factors that will help the small business qualify for a loan—aside from a successful track record—are good cash flow, a favorable debt-equity ratio, and carefully prepared documentation.

Net Cash Flow to Debt

The lender first looks at a loan-applicant's cash flow because it is the source of loan repayment. Cash flow is often different from the profitability or assets of a business because sales booked appear on the books immediately but may show up as cash only later (when payment is received) and purchases made are immediately shown as costs but may only require cash later (when payments are actually made). The lender will initially calculate the amount of cash available to service the current portions of any new debt. If this amount is minimally 1.25 times the debt service required, the business is at least in the ballpark to receive a loan. A company with a net cash flow of $5,000 a month and a future debt with a $1,750 monthly payment, has a ratio of cash to debt of 2.86—plenty, in other words. To be sure, the lender will look for a history of such cash flows: a two-month history will not be enough. The higher this ratio and the longer the history, the more inclined the lender will be to lend. If the cash flow is lower, the battle is almost certainly lost—for now.

Debt-Equity Ratio

This ratio is calculated by taking a company's liabilities and dividing them by the company's equity. A ratio of 1 means that for every dollar in equity the company has 1 dollar of debt. A company with no debt at all will have a debt-equity ratio of 0. Using data provided by MSN Money, in 2006 the combined debt-equity ratios of all companies part of the S&P 500 Stock Index was 1.04, suggesting that debt was just a hair greater than equity in these leading companies. But this ratio varies industry to industry. In capital-intensive industries the ratio will be significantly higher; in others much lower. In 2006 Microsoft's ratio was 4 cents to each dollar of investment; General Motors, struggling to stay solvent, had a ratio of nearly $20 in debt for each $1 of equity; General Electric's ratio was $1.94 to $1.

The ratio will tell the lender the commitment investors have made in the company, and the higher this commitment is in relation to borrowing, the more confidence the lender will have in being repaid.

Documentation

In addition to favorable financial ratios, the lender will be looking at the company's performance over time. The borrower should anticipate providing the lender a loan proposal justifying the loan. Parts of that proposal will be a business plan, financial statements, and details on other debts and liabilities. Sometimes unfavorable ratios can be overcome by a consistent history of profitable performance and high growth—and even innovative plans with high potential for success will carry weight. But the wise business owner will not bet on that.

The New Automation

In the modern lending environment, computers and the Internet have amplified (and sometimes even usurped) the role of lending officers at financial institutions. One such development is loan origination software (LOS) offered by a number of companies over the Internet to banks, credit unions, and other financing agencies. These packages automate judgment on loan applications by calculating ratios, using averages for industrial categories, weighting experience factors, and even obtaining credit ratings automatically. One such package is LiquidCredit Bank2Business offered by Fair Isaac Corporation, a leading company in the field—but there are a number of others. These packages "score" loan applications and thus give loan officers confirmation for their own judgment—or give them pause. Downsizing in the banking sector, as reported by Mike Byfield in Alberta Report has caused an increase in caseloads and thus reliance on such services. So much for the bad news. The good news is that capital markets in the mid-2000s were flush with money. Conditions continuously change and cycle, to be sure, but the well-prepared business owner with good justification can still prevail and get his or her loan. That, of course, is just the beginning of getting on with the program.

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