When you apply for a consumer loan such as a credit card or auto loan, you probably know that most lenders will look at your credit score and your income to decide whether to approve your application. But small business loans can be more complicated. There are many different types of loans, each with different approval criteria. Most of them use three main factors to evaluate loan applications: revenues/cash flow, time in business and credit.
Most lenders want to understand whether the business has the capacity to repay the loan. Depending on the type and size of the loan, there may be different types of documentation required.
For a bank loan, for example, you will likely have to provide two years (or more) business tax returns along with at least three months of business bank statements.
Most online lenders won’t require detailed financial statements. Instead, they will analyze bank account activity to make a quick credit decision. With this type of loan, the lender may request business bank account statements (3-6 months’ worth). It may require you to link your bank account so the lender can review your bank account activity. Each lender is somewhat different, but they will be looking for things like:
Some businesses try to keep cash deposits “off the books” to minimize taxes. Understand that if you do that, you may not be able to get as much financing as you would if that income was documented.
Many businesses fail, and those that don’t make it often fail in the first few years. As a result, lenders want to see a successful track record. Here, they will take into account how long your business has been in operation.
Many lenders prefer to lend to businesses with at least two years in business. Make sure you have established an official start date for your business, whether that’s the date you incorporated or the date you received your Employer Identification Number (EIN) or a business license. Be consistent and use that date when applying for credit.
Some small business lenders check business credit, some check personal credit, and a few don’t check credit at all.
If a lender checks your business credit through commercial credit bureaus, it may be looking at your business credit score, checking your to see if your business has a positive payment history, or it may simply be checking for red flags such as late payments, tax liens or collection accounts.
Sometimes lenders will review business credit reports to check for UCC filings. UCC filings are a type of court record that indicate other creditors have a security interest in property of the business.
Many small business lenders also check the owner’s personal credit. That credit check may be a soft inquiry which doesn’t impact your scores, but that is not always the case. If you’re concerned about a credit check, ask the lender about its policy.
Banks, credit unions and other traditional financial institutions (including those that make SBA loans) will usually require good credit (or even excellent credit). They may check credit scores on each business owner with a specific ownership percentage. (In the case of SBA loans, a credit check is usually required for any business owner that owns 20% or more of the business.)
Credit scores may be used both to approve a loan as well as to help determine the interest rate that will be charged.
There is a fourth factor that will likely impact your loan options, and that’s the industry in which you operate. Small business lenders may prefer to lend to businesses in certain industries, or they may avoid others they deem too risky or that simply aren’t a fit. These will be referred to as “restricted industries” by the lender. (For example, some lenders specialize in medical or veterinary practices, for example. Others won’t lend to businesses involved in certain types of real estate construction, used car lots or adult entertainment venues, for example.)
You may have heard of the 5 C’s of lending. These are used to help describe the eligibility factors lenders may look for during the underwriting process. Here are some of the questions a loan officer may have in mind as it reviews your loan application:
Character: Will you repay the loan? Here the lender will review your credit history to see whether other debt has been paid on time.
Capacity: Can you repay the loan? Does your business have sufficient monthly income and cash flow to make payments? The lender may look at financial ratios here. In the consumer lending world, it would be a debt to income ratio, while in the business financing world it may be a debt service coverage ratio.
Collateral: Do you have some type of collateral that could be repossessed if you don’t pay it back? This may include equipment or other physical assets of the business, personal assets such as home equity or even future receivables of the business.
Capital: How much have you invested in the business? You may hear this referred to as a down payment, equity injection, or informally as “skin in the game.”
Conditions: What are the terms of the loan—interest rate along with daily, weekly or monthly debt payments— that may impact your ability to repay it? The lower your interest rate, the lower your monthly payments will be, if all other factors are equal. What are the conditions in the industry and/or economy that may impact the business and its future success? Some banks may want a business plan to help document this.
Keep in mind that even an online business loan application may include an automated review of some of these factors. While a loan officer may not review each credit report, for example, there may be a minimum credit score. Or by linking your bank account, revenues may be evaluated to help determine whether the new loan payments will be affordable.
If this leaves you feeling overwhelmed, you’re not alone. Small business lending can feel confusing. There are a few simple steps you can take to make it easier, though:
1. Use a business bank account. Make sure you are using a business bank account for all your business income and expenses. Don’t mix personal expenses; if you need to make a personal purchase, pay yourself and then pay for those expenses through your personal accounts. Keep your bookkeeping up to date so if a lender requires financial statements, it won’t be difficult to pull those together.
2. Check and monitor your business and personal credit. If you have business partners, it’s a good idea to discuss your credit scores with each of the major credit bureaus so you all know what to expect if you decide to apply for financing with a lender that checks personal credit. (Here’s a list of 138+ places to check your credit scores for free.)
3. Look for financing before you need it. Borrowers who scramble for financing rat the last minute are not likely to get a great loan. At a minimum, you may want to secure a line of credit or at least get a business credit card so you’ll have that credit available if an opportunity (or crisis) comes along.
This article was originally written on October 21, 2021.
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Education Director for Nav
Gerri Detweiler is Education Director for Nav. Known as a financing and credit expert, she has been interviewed in more than 4000 news stories, and answered over 10,000 credit questions online. Her articles have been widely syndicated on sites such as MSN, Forbes, and MarketWatch. She is the author or coauthor of five books, including Finance Your Own Business: Get on the Financing Fast Track. She has testified before Congress on consumer credit legislation.
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