Putting together a loan package and securing financing from a lending institution can be a formidable task, particularly for the first-time borrower. An understanding of how lenders review (and approve) loan applications is key to developing a successful borrowing relationship.
Some lending institutions have a standard application that all prospective borrowers are required to complete for loans of a particular size. In those instances, your task is made easier: the bank has defined the type and amount of information it requires in order to assess your business.
Frequently, though, lending decisions are made on the basis of a submitted business plan. While this component may make it time consuming to assemble a loan package, borrowers have an opportunity to offer their lender an in-depth view of their business. In addition, putting together a business plan is also a good tool for systematically thinking through the nature and performance of your business.
Regardless of whether you are borrowing from a conventional bank, credit union, revolving loan fund or savings and loan association, commercial lending techniques involve the analysis of several factors, including:
- the company's industry outlook;
- its growth prospects;
- its historical and projected financial performance;
- an assessment of management.
Understanding how lenders review loan applications is key to developing a successful borrowing relationship.
As a loan applicant, your job is to present this information in an accurate and concise fashion, highlighting those issues that are unique to your business.
Your lending institution must become knowledgeable about the industry in which your company is operating. For example, what changes has the industry faced over the last two to three years (e.g., pricing, distribution, regulation)? Are significant changes anticipated? Is this industry generally in a growth period? A declining period? The outlook for the industry will affect the lender's assessment of your proposal.
Your bank will also want to take a detailed look at the specific market in which your company is located, with an eye towards prospects for growth. For example, what are the local economic and demographic trends that will affect your business? Have new competitors moved into the market, and if so, what are your plans? Does your product and service mix meet present and anticipated market demand? How does your marketing strategy (pricing, distribution, sales) meet the current and projected market conditions?
Your lending institution will also undertake a comprehensive analysis of your business' historical and projected financial performance. Typically, lenders are concerned with primary source of repayment -- in short, your company's ability to generate sufficient cash to repay their debt. In this regard, most businesses will be assessed through four measures: profitability, liquidity, operating efficiency, and solvency. There are a variety of financial ratios used to assess historical operating performance (see sidebar). It's important to note that ratios are only meaningful if they are compared against a baseline -- industry statistics are widely available and can be used to compare you company's performance against similar businesses.
Commonly Used Financial Ratios
- gross margin
- selling, general and administration (percent of gross sales)
- net margin
- return on average assets
- receivables in days
- inventory in days
- accounts payable in days
- total assets/net sales
- working capital
- quick ratio
- current ratio
- sales/net working capital
- total liabilities/net worth
- long term debt/net fixed assets
Historical (audited) financial statements are useful predictors of future performance. Equally important, though, are the assumptions underlying your proposal. Are the revenue and expenses projections reasonable in light of past performance? For example, can you substantiate aggressive growth rates in projected sales if your historical averages have been low?
The quality of your business is directly tied to management. Lenders will look at the stability, experience, and depth of management in evaluating current and future performance. How long has the current management team been in place, and what are their backgrounds in similar and related kinds of businesses? Is there a "second tier" management team identified? If you are undertaking a new venture, what kinds of past experience can management offer to ensure its success?
Finally, become informed about your source of financing. Generally, the more you know about your lender, the more successful you will be in securing a loan. How many loans did the lender extend last year to businesses in your particular industry? Is there a loan maximum amount, or minimum? What kinds of financial services does the lender offer? Can the lender accommodate the kinds of services that your business needs? What is the nature of the loan application process? And what factors are critical to the lender's decision?