A lot of small business owners we work with feel that the underwriting process for a bank loan is a black box that is impossible to peer through.
But in its simplest form, underwriting is just a test to answer two simple questions:
- Does your business have the ability to repay the loan?
- What can be collected and sold if your business defaults on the loan?
To answer these two questions, lenders rely on various pieces of information about you and your business to help them make the decision to extend credit. That information can be distilled into four categories and is commonly referred to in the finance industry as the Four C’s: character , collateral, conditions, and capacity. Let’s examine each of the Four Cs in greater detail and find out how they can impact your ability to get a loan.
Character
Even if you have millions of dollars in cash, lenders will hesitate to lend to you if you don’t demonstrate a history of paying your debts. By reviewing your personal and business credit reports, a lender can quickly see how you manage your finances. Do you pay on time? Have you defaulted on previous loans? Do you have liens or judgments from creditors? In a personal credit report, the credit bureaus provide information on your payment habits, derogatory marks, liens, judgments and bankruptcies.
A FICO score of 670 and above is typically judged as a good credit score. Lenders use this information to get a sense of how responsible you are and whether you manage your finances well. In the US, Equifax, TransUnion and Experian are the three consumer credit reporting agencies that can provide personal credit reports to creditors. For your business, Dun & Bradstreet, Equifax, and Experian are the three main business credit reporting companies that can provide reports on your business to lenders. These companies track your payment history with vendors and suppliers, your business financials, and how your business stacks up against your peers .
Business credit information is not as prevalent though as personal credit information, because you need to sign up with these credit reporting companies to have them track your information.
Collateral
Collateral is the value of assets that can be used to repay a loan should you default on it. Here is where a balance sheet and personal financial statement comes in handy. Off of a balance sheet, a lender can see what assets your business has - not to mention what your liabilities are. Many lenders will place a lien on your business giving them the ability to seize your business and sell off its assets if you default on your loan.
So the more business assets that you have, the more comfortable a lender will be in giving you money. Just remember that these assets have to have resale value so some things such as say office furniture will give little comfort to your lender. A lender will also ask for a debt schedule. A debt schedule is a document that outlines all the other financial debts you have. The document tells a lender where the debt came from, how much is left to repay, what rate you pay on that debt, and the collateral backing those instruments.
It’s important for the lender to know whether there are other lenders that have a lien on your assets and a debt schedule helps them to determine that. A personal financial statement tells a lender what kind of assets you own personally. Sometimes lenders will ask you to personally guarantee a business loan making you specifically liable should your business not be able to repay the loan. If the loan has a guarantee from the SBA, expect the personal guarantee requirement.
Conditions
Chances are small that a lender will lend to you if they are not comfortable with the industry that your business is in or if they don’t see a strong market in what you are doing. Many lenders, for instance, do not lend to startups or businesses less than a year old as they have not demonstrated their ability to weather different market cycles. Some businesses are classified as high risk because of the generally high failure rates of other businesses that have come before you.
Retail stores, restaurants, and pubs come to mind where many fail within their first year of operations or run on very tight margins. To address your lender’s anxiety about your industry make certain that you have a great business plan and a well thought out strategy on how your business is going to differentiate itself. If you know that you fall into the high risk category, don’t shy away from the problems in your industry instead address the issue head on in your plan. By explaining how you are different to others that have failed will go a long way in getting your lender to lend.
Capacity
Capacity simply refers to your business’ ability to repay a loan and whether this ability may become impaired over the course of the loan. This area is probably the single most important part of the underwriting process. To determine your capacity, a lender will ask you for your tax returns, year-to-date profit & loss statement, and business bank statements. From these documents, lenders will look for your profitability trend, revenue growth, and cash coming into the business.
The idea is to calculate a “coverage ratio” between your cash flow/income and your debt payments. Naturally, the more coverage you have on your debt payments, the more likely a lender will approve you for a loan.
Summing it all up
Loan underwriting is no black box. It is simply a matter of answering the two questions we posed at the beginning of this article. A lender will need all the documents that we discussed to answer those two fundamental questions. So before you begin your search for a loan, make sure that you’ve spent some time preparing these documents because it will save you a lot of headache and time when you start talking to your lenders about credit.
