This article will explore what an average bank expects from a small business loan applicant. The information provided below will help a small business owner determine whether a bank loan is the correct financing option for his or her business.
Brad Nakase, Attorney
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Madeleine has recently opened her own tattoo parlor. She is excited to hire talented artists from across the state to come work for her. However, she first needs to buy the proper equipment. Sadly, the cost of opening the business has left Madeleine in need of funds. She has heard that she can apply for a bank loan. However, she has also heard that the application process is long and difficult. She wonders what the requirements are for a bank loan, and whether she and her business qualify.
It is common for small businesses to require additional financing, and indeed, supplementary funds can be critical in the business surviving and thriving. Without this extra money, a business owner may not be able to afford inventory, equipment, payroll, and other essential costs. Because of this, a lot of business owners decide to apply for bank loans to meet their financing needs.
Unfortunately, it is often necessary to meet specific loan requirements to qualify for a bank-issued loan. Most of the time, small business owners cannot meet all of the demanding requirements. Even if a small business meets the strict requirements, the process of obtaining a loan can be long and difficult. This may present a problem for a business that needs funds immediately in order to survive.
The following ten items make up the typical requirements that a bank demands of small business owners.
Some banks, known generally as lenders, do not have usage restrictions. However, most banks will want to know how a small business plans on spending the loaned money. For example, some small businesses will have a hard time securing a loan from a bank if they plan on using the loan to pay off existing debt. In addition, to qualify for an SBA loan, a small business will usually have to prove that it needs funding for an approved reason.
The good news is that banks will typically approve small businesses using loans for a number of common reasons. These reasons include the following:
A small business owner may be worried about a bank examining how their loan will be used. For concerned individuals, it is possible to apply for financing from alternative lenders, some of them online. Usually, these lenders do not have usage restrictions, so a small business owner will be able to use a loan as he or she would like.
It is common for small business owners to work with alternative business lenders because hey are free to use the funding however they wish. They are not required to spend the money on a pre-approved cost.
Example A: Connie runs a bakery. She is currently having trouble affording specialist equipment, such as an industrial ice cream maker. She applies for a loan from the bank, explaining that she would like to use the money for this purpose. The bank approves her loan.
Example B: Rafael runs an art studio, which has taken on a significant amount of debt. Rafael is applying for a bank loan to pay off this debt. However, the bank rejects his loan application, because it does not want the money to be used for this reason. Rafael is able to secure a loan from an alternative lender who is not picky about how the money is used.
When reviewing loan applications, banks will often take into account how much experience a small business owner has. If a business owner has managed a business for years and has shown that they are responsible with money, then the bank will look upon him or her favorably. However, if a small business owner has just opened their business or has struggled financially in the past, he or she may have more trouble securing a loan. They have not shown the bank that they can be trusted with money, however harsh this sounds.
In the end, a bank is more likely to approve a small business’ loan application if it believes that the business will succeed after receiving the loan. It does not want to fund a business doomed to fail, because the bank would then not receive its money back. If the lender is not confident that the small business can submit its monthly payment on time, then the business is unlikely to get approved for a loan.
Example: Karina has just opened a new restaurant; however, she is already having trouble with finances. In order to fund her payroll, she has applied for a bank loan. The bank loan studies Karina’s application and discovers that she had a previous restaurant that failed six months from its founding due to lack of cash. The bank is worried that Karina’s new business will also fail, and that she will thereby not pay back the loan. Karina’s loan application is therefore rejected.
When a small business applies for a bank loan, it will need to submit a business plan. While this may seem like a time-consuming, difficult task, a business plan is a useful way for the bank to determine the appropriate loan amount and term for the company.
Prior to submitting a business plan, a small business owner should ensure that it accurately represents the business’ goals, finances, as well as any other relevant information. A business may benefit from having another entrepreneur look at the plan to provide advice or feedback. This may make the difference between loan approval and rejection.
Example: Joan is the owner of an organic market. She needs money for inventory, so she is applying for a bank loan. She is sure to put together an impressive business plan, detailing her goals for the company. She also includes information about the business’ finances to appear transparent. Joan also consults Fred, the owner of a local restaurant, who reviews her business plan and gives her feedback. She edits her plan accordingly and submits it to the bank, who are convinced by her plans for the business. They approve her loan.
When a bank considers a business for a loan, it will normally perform a credit check. The purpose of the credit check is to determine the owner’s personal credit score, as well as the credit score of the business. Personal credit history is especially important for companies that are classified as sole proprietorships or partnerships. In these cases, a business owner has partial or total financial responsibility over the business. Therefore, his or her personal credit score is an important predictor of whether the business will pay back its loan.
Prior to applying for a bank loan, a business owner should be aware of both his or her personal credit score as well as that of the business. If the credit scores are below the minimum requirements of the bank, then the owner should spend time trying to raise the scores before applying for a loan.
A small business owner should get a personal credit report from one of the three main credit unions: Experian, Equifax, and TransUnion. It is also possible to figure out the business’ credit score by asking for a free Business Information Report from Dun & Bradstreet.
If a small business or its owner does not have a fantastic credit score, then it is likely the business will not be approved for a bank loan because of the bank’s credit requirements. In fact, even if a small business does qualify for a business loan, the credit score might negatively impact the interest rate. It is therefore clear that an excellent credit score is very important. For those with a sub-par credit score, it might be a better idea to find other financing options rather than apply for bank-issued financing.
Indeed, there are some lenders who specifically focus on providing loans to small business owners with poor credit scores. Certainly, there are some lenders who are at least more open to the idea of working with an owner who does not have a fantastic score. One should therefore take stock of their credit score, of that of their business, and decide what lender would be most appropriate and willing to work with them.
Example: Herbert owns a comic book shop. He is applying for a bank loan to finance his payroll. However, when Herbert uses Experian to check his personal credit score for the bank, he discovers that it is very low at 560. The bank, he is aware, requires a credit score of 700 or above to approve a loan. They are concerned that Herbert may be unable to pay them back, based on his history. So, Herbert researches other lenders who may be willing to help him. He finds a lender who is willing to loan him money despite his low credit score.
Unfortunately, it is possible that personal information could affect one’s ability to qualify for a bank loan. As mentioned in the above section, a business owner’s personal credit score can affect his or her eligibility for a loan. A poor credit score can be disqualifying. In addition to credit score, banks also ask that other forms of personal information be included in the loan application. This information includes the following:
Example: Shelly is the owner of a seafood restaurant. She is applying for a bank loan so that she can afford new kitchen equipment for her chefs. The bank asks Shelly to provide personal information, including any record of felonies or misdemeanors. Unfortunately, Shelly has a criminal history. Ten years previously, Shelly attempted to rob a bank. As a result, the bank determines that Shelly cannot be trusted with a loan, and her application is rejected.
Besides personal information, a small business owner will also need to submit his or her business’ financial statements. The number of statements required will depend on the particular bank and their requirements.
Most banks will ask for the following documents to be provided:
After a business owner submits this information, the bank will study these documents to assess whether the owner is a strong candidate for a loan.
Example: Joe is the owner of a cat café. He is applying for a bank loan so that he will have the funds to provide each of the café’s cats veterinary services. In order to be approved for the loan, Joe is sure to provide evidence of the company’s good financial standing. He offers the bank a balance sheet, profit and loss statements, cash flow statements, and other financial documents. He also provides projections that show the business making a profit over the next few years. The bank studies his information and is reassured that the business is financially healthy and will not go under. They feel safe giving Joe a loan, trusting that they will get their money back.
If a small business owner’s personal credit history, or that of their business, does not meet the bank loan requirements, it may still be possible to receive financing by offering collateral. Collateral, according to banks, may be defined as business or personal property that an owner puts up to guarantee that a loan is repaid.
The bank will want collateral that matches the value of the desired loan. Typically, banks want structural collateral for large loans, which might include a home or an office. Business collateral may often include equipment or inventory. So, for example, a business owner may offer an expensive piece of machinery as collateral, perhaps to secure a $10,000 loan.
Other forms of collateral include expensive jewelry, vehicles, and fancy antiques. The expected life of the collateral must match the lifespan of the loan. Therefore, a business owner cannot offer a 1994 Honda Civic on its last legs as collateral for a $50,000 loan.
If a business owner is taking out a loan for a particular kind of inventory or equipment, that item might be considered collateral. For instance, if a business owner is taking out an auto loan to purchase a truck, then he or she may use the truck as collateral in the event the loan cannot be repaid. If that happens, the bank will seize the truck as a form of repayment.
Example: Frank is the owner of a restaurant. He would like to buy a fancy oven from Paris that is worth $10,000. Since he does not have the funds for this purchase, he decides to take out a bank loan. However, the bank asks for collateral worth the cost of the oven. Frank is about to use his wife’s wedding ring as collateral, but his furious wife reminds him that the oven itself can serve as collateral. If Frank fails to repay the loan, then the bank can always seize the French oven as a way of getting its money back.
When studying small business’ loan applications, banks are primarily concerned about the business’s cash flow. They want to know whether the company can generate enough money to repay a bank loan within the agreed-upon period. The bank will therefore ask a business owner to provide information about the business’ main source of cash. Of course, most banks understand that managing cash flow is difficult for any business, especially for companies that operate on a seasonal basis.
Example: Tim is the owner of a seasonal Christmas tree business that operates every year from October to January. Tim is applying for a bank loan so that he may purchase better equipment to harvest the spruce trees. The bank would like evidence of Tim’s cash flow, so that they are assured he will repay the loan on time. Unfortunately, because Tim’s company operates seasonally, he does not enjoy regular cash flow. While he makes a lot of money in the winter, he does not make much money during the rest of the year. Luckily, the bank understands his circumstances and adjusts the loan period accordingly.
It is common for small business owners to apply for a business loan before paying off other loans and debts, which might include their credit card balance.
While one can understand the need for additional financing, applying for a separate loan can often hurt a business owner’s credit.
Not only will a business owner need to worry about paying off debts, he or she will also need to maintain their business. The costs of running the business will include the following:
In general, lenders will not want to approve clients who already have outstanding debt. This is because the business owner will likely be unable to repay the loan in the agreed-upon period. Therefore, if a business has a loan that still needs to be repaid, it is unwise to apply for an additional loan. The most likely outcome is rejection.
Example: Theodore is the owner of a garage that fixes cars. In the past few years, he has taken out several loans in order to afford equipment and machinery. Sadly, his business has not made enough profit to pay back these loans yet. He is applying for an additional loan to help pay back the other loans. However, the new bank sees that Theodore has outstanding loans that he has failed to pay back, and as a result, rejects his application.
Individuals who have applied for a personal loan will know that a lender sometimes asks that the candidate sign a personal guarantee. Sometimes, a person may need to sign such a document to secure a bank’s small business loan.
This document serves as a written promise. It states that a business owner will repay his or her small business loan using personal assets if the business cannot pay the loan balance by a certain date.
It is possible that the bank will require a business owner to promise certain assets as additional security. These collateral assets might include personal savings, a home, or investments.
Example: When Gary applies for a small business loan, the bank has him sign a personal guarantee. He is required to list his home as collateral. In the event Gary cannot repay the loan in the agreed-upon period, the bank will seize his home.
While the application process involved in receiving a small business loan can appear intimidating, with thoughtful planning, a business has ever chance of obtaining financing. If a small business owner would prefer to avoid the stress altogether, he or she is free to pursue a business loan from an alternative lender.
Learn more about: Business | Corporate | Employment Law
See all articles: Business | Corporate | Employment
See all articles: Business | Corporate | Employment