What banks look for when reviewing a loan application

Not all banks are created equal, but many of them focus on the same areas throughout the loan review process. Learn what documentation, projections and narratives you'll need to prepare as well as tips to ensure you negotiate the best loan package available.

Whether you are applying to a bank for:

• A line of home equity credit
• A line of credit for business working capital
• A commercial short-term loan
• An equipment loan
• Real estate financing
• Some other type of commercial or consumer loan

Many of the same basic lending principles apply.

Five keys of loan applications

1. The most fundamental characteristics most prospective lenders will concentrate on include:

2. Credit history

3. Cash flow history and projections for the business

4. Collateral available to secure the loan

5. Character

6. Myriad pieces of loan documentation that includes business and personal financial statements, income tax returns, a business plan and that essentially sums up and provides evidence for the first four items listed

The first three of these criteria are largely objective data (although interpretation of the numbers can be subjective). The fourth item—your character—allows the lender to make a more subjective assessment of your business's market appeal and the business savvy of you and any of your fellow operators. In assessing whether to finance a small business, lenders are often willing to consider individual factors that represent strengths or weaknesses for a loan.

Tools to use

To give you an idea of what banks specifically focus on when reviewing a loan request, the Tools & Forms section contains a sample business loan application form that is typical of the kind of documentation you'll need to complete as part of your loan application package.

We also include an internal bank loan review form used by one small community bank to make its own review of a small business loan.

Credit history

Lenders will want to review both the credit history of your business (if the business is not a startup) and, because a personal guarantee is often required for a small business loan, your personal credit history. We recommend obtaining a credit report on yourself and your business before you apply for credit. If you discover any inaccuracies or problems, you can correct them before any damage to your loan application has occurred. If you can, find out which credit reporting company your prospective lender uses and request a report from that company.

Reviewing your commercial credit history

Before you apply for commercial credit, you should review a credit report on your own business, if your business has been in existence for a while. You can obtain a free Business Information Report on your own business from Dun & Bradstreet.

If D&B does not yet have any information on you, they will allow you to voluntarily obtain a listing by providing them with some basic information about your business.

Most conventional lenders will expect a minimum of four or five trade experiences listed on a business report before they consider the business creditworthiness. If you have been operating your business without credit, or with personal assets, you should consider making some trade credit purchases in order to establish a credit history for your enterprise.

Reviewing your consumer credit history

Consumer credit agencies are required to remove any information from the report that cannot be verified or has been shown to be inaccurate. However, before you submit a letter disputing any debt to the credit reporting company, it's often a good idea to contact the relevant creditor directly. If an error was made, you can often clear up the dispute more quickly if you take the initiative.

If the dispute is not resolved and your credit report is not adjusted, you have the right to file a statement or explanation regarding the alleged debt with the credit report. If your credit report does have some tarnish on it, you might consider requesting that any creditors with whom you have had a good credit history, but who did not report the transactions, be added to the report. For a minimal fee, most credit bureaus will add additional creditor information.

Work smart

The three major consumer credit reporting companies are TransUnion, Experian, and Equifax. Dun & Bradstreet is the largest business credit reporting agency.

Providing collateral to secure a loan

When it comes to obtaining a secured loan, providing collateral is a must. To a bank, collateral is simply defined as property that secures a loan or other debt, so that the lender may be seize that property if the you fail to make proper payments on the loan.

Understanding your collateral options

When lenders demand collateral for a secured loan, they are seeking to minimize the risks of extending credit. In order to ensure that the particular collateral provides appropriate security, the lender will want to match the type of collateral with the loan being made.

The useful life of the collateral will typically have to exceed, or at least meet, the term of the loan. Otherwise, the lender's secured interest would be jeopardized. Consequently, short-term assets such as receivables and inventory will not be acceptable as security for a long-term loan, but they are appropriate for short-term financing such as a line of credit.

In addition, many lenders will require that their claim to the collateral be a first secured interest, meaning that no prior or superior liens exist, or may be subsequently created, against the collateral. By being a priority lien holder, the lender ensures its share of any foreclosure proceeds before any other claimant is entitled to any money.

Protecting your collateral

Properly recorded security interests in real estate or personal property are matters of public record. Because a creditor wants to have a priority claim against the collateral being offered to secure the loan, the creditor will search the public records to make sure that prior claims have not been filed against the collateral.

If the collateral is real estate, the search of public records is often done by a title insurance company. The company prepares a "title report" that reveals any pre-existing recorded secured interests or other title defects.

If the loan is secured by personal property, the creditor typically runs a "U.C.C. search" of the public records to reveal any pre-existing claims. The costs of a title search or a U.C.C. search is often passed on to the prospective borrower as part of the loan closing costs. In startup businesses, a commonly used source of collateral is the equity value in real estate. The borrower may simply take out a new, or second, mortgage on his or her residence. In some states, the lender can protect a security interest in real estate by retaining title to the property until the mortgage is fully paid.

Determining a loan-to-value ration

To further limit their risks, lenders usually discount the value of the collateral so that they are not extending 100 percent of the collateral's highest market value. This relationship between the amount of money the bank lends to the value of the collateral is called the loan-to-value ratio. The type of collateral used to secure the loan will affect the bank's acceptable loan-to-value ratio. For example, unimproved real estate will yield a lower ratio than improved, occupied real estate. These ratios can vary between lenders and the ratio may also be influenced by lending criteria other than the value of the collateral. Your healthy cash flow may allow for more leeway in the loan-to-value ratio. A representative listing of loan-to-value ratios for different collateral at a small community bank is:

• Real estate: If the real estate is occupied, the lender might provide up to 75 percent of the appraised value. If the property is improved, but not occupied, such as a planned new residential subdivision with sewer and water but no homes yet, up to 50 percent. For vacant and unimproved property, 30 percent.

• Inventory: A lender may advance up to 60 percent to 80 percent of value for ready-to-go retail inventory. A manufacturer's inventory, consisting of component parts and other unfinished materials, might be only 30 percent. The key factor is the merchantability of the inventory—how quickly and for how much money could the inventory be sold.

• Accounts receivable: You may get up to 75 percent on accounts that are less than 30 days old. Accounts receivable are typically "aged" by the borrower before a value is assigned to them. The older the account, the less value it holds. Some lenders don't pay attention to the age of the accounts until they are outstanding for over 90 days, and then they may refuse to finance them. Other lenders apply a graduated scale to value the accounts so that, for instance, accounts that are from 31 to 60 days old may have a loan-to-value ratio of only 60 percent, and accounts from 61 to 90 days old are only 30 percent. Delinquencies in the accounts and the overall creditworthiness of the account debtors may also affect the loan-to-value ratio.

• Equipment: If the equipment is new, the bank might agree to lend 75 percent of the purchase price; if the equipment is used, then a lesser percentage of the appraised liquidation value might be advanced. However, some lenders apply a reverse approach to discounting of equipment. They assume that new equipment is significantly devalued as soon as it goes out the seller's door (e.g., a new car is worth much less after it's driven off the lot). If the collateral's value is significantly depreciated, loaning 75 percent of the purchase price may be an overvaluation of the equipment. Instead, these lenders would use a higher percentage loan-to-value ratio for used goods because a recent appraisal value would give a relatively accurate assessment of the current market value of that property. For example, if a three-year-old vehicle is appraised at $15,000, that's probably very close to its immediate liquidation value.

• Securities: Marketable stocks and bonds can be used as collateral to obtain up to 75 percent of their market value. Note that the loan proceeds cannot be used to purchase additional stock.

Establishing your cash flow from operating your business

The cash flow from your business's operations—the cycle of cash flow, from the purchase of inventory through the collection of accounts receivable—is the most important factor for obtaining short-term debt financing.

Understanding your cash flow cycle

A lender's primary concern is whether your daily operations will generate enough cash to repay the loan. Cash flow shows how your major cash expenditures relate to your major cash sources. This information may give a lender insight into your business's market demand, management competence, business cycles, and any significant changes in the business over time.

Tools to use

Included among the Tools & Forms is a cash flow budget worksheet. The worksheet is an Excel template that can be used in Excel 4.0 or higher. Because it's a template, you can use the worksheet over and over again and still retain an original copy of it. The worksheet is set up to be used for projecting your cash flow for six months. We've formatted the worksheet and put in most of the cash inflow and outflow categories for you. All you have to do is put in your numbers and print it. While a variety of factors may affect cash flow and a particular lender's evaluation of your business's cash flow numbers, a small community bank might consider an acceptable working cash flow ratio—the amount of available cash at any one time in relationship to debt payments—to be at least 1.15:1. As most lenders are aware, cash flow also presents the most troubling problem for small businesses, and they will typically require both historic and projected cash flow statements. In preparing cash flow projections for newer businesses, you may want to refer to any one of several sources that publish sales/expense ratios for specific industries. The ratios will help you compute realistic sales revenues and the proportion of expenses typically necessary, in that industry, to generate the projected sales revenue.

Warning

A business's cash flow will usually include not only the money that goes in and out of the business from its operations (sales less expenses), but also any cash flow from investments or financial activities (e.g., payments and receipts of interest and dividends, long-term contracts, insurance, sales or purchase of machinery and other capital changes, leases, etc.) However, the most important component to a lender is simply whether the business's ongoing sales and collections represent a sufficient and regular source of cash for repayment on a loan. Because of the attention that cash flow receives, you may want to consider our suggestions for improving your positive cash flow.

Improving your cash flow

If you're trying to improve your odds of getting a business loan, we suggest you review the following practices of your business:

• Pay off, or delay paying, debt. If possible, pay off existing debt or refinance the debt for a longer maturity with lower payments. For other debts, try to renegotiate payment lengths. Believe it or not, some creditors may allow some delinquencies as long as some money is coming in. In some situations, you may simply have to prioritize those creditors who must be paid because they are providing necessities—such as utilities, certain suppliers, payroll, etc.—and try to delay payments to creditors who are less likely to halt your business—like secondary suppliers.

• Collect receivables. Try to quickly collect overdue accounts. Revenues are lost when a firm's collection policies are not aggressive. The longer your customers' balance remains unpaid, the less likely it is that you will receive full payment.

• Reduce credit allowances and accelerate cash receipts. If you can tighten credit terms without losing good customers, you can increase available cash on hand and reduce the bad debt expense. You can also encourage cash sales through discounting and pricing policies. In addition, try to reduce the float time on customer payment checks. You can do this by undertaking prompt processing of checks as you receive them, using a bank lockbox arrangement in which you pay a fee for the bank to collect and process all incoming payments, and by shopping for a bank that quickly processes negotiable instruments.

• Increase revenues. While this suggestion is an obvious goal of every business, a poor cash flow may indicate that you need to seriously reconsider what steps you can take to increase sales revenues by either raising sales volume and/or altering prices. In reviewing ways to increase cash flow through increased sales, guard against allowing too many credit purchases. Extending credit will increase your accounts receivable, not your cash.

• Reduce inventory. If you can reduce the amount of inventory you maintain, your cash outflow should decrease.

• Review tax strategies that may help cash flow with your accountant. For instance, a tax credit may be available for job opportunities you create for certain disadvantaged employees, "qualified research" (research and development) costs or the expenses of property renovation or rehabilitation of certain qualified buildings. In addition, accelerated depreciation on certain equipment and tangible property may be available to increase your short-term tax deductions.

For more ideas on this subject, see our detailed discussion of improving your cash flow.

Assessing your character as a potential business borrower

The weight given to a lender's assessment of a borrower's character can vary tremendously between lending institutions and between individual lending officers. Many small businesses have found more success "selling" their reputation and good character to smaller community banks who may be more directly affected by the economic health of the surrounding community.

To ensure you're selling yourself well to your lender, we've compiled the most important steps to follow.

Improving your character in front of lenders

As a general rule, the following traits are considered the most important when a bank considers your character:

• Successful prior business experience
• An existing or past relationship with the lender (e.g., prior credit or depositor relationship)
• Referrals by respected community members
• References from professionals (accountants, lawyers, business advisers) who have reviewed your proposals
• Community involvement
• Evidence of your care and effort in the business planning process

Many banks consider the amount of investment the owners themselves are committing to the business as evidence of a borrower's "character." On top of that, many commercial lenders want the owner to finance between 25 percent to 50 percent of the projected cost of a startup business or new project. If your investment is considered insignificant, a lender may consider it a lack of both owner confidence and dedication to the business.

Warning

One banker noted to us that he often relies upon reaching a personal "comfort level" with a borrower before making a loan. This comfort level is based upon the degree of trust or confidence that the banker has in the accuracy of the information and documentation being presented to him. He observed that in their zeal to "sell" him on the profitability of their business, small business borrowers sometimes talk him out of this comfort level by disclosing that their tax returns underreport income and overstate expenses. Such disclosures cast doubt upon the credibility of the loan applicant, and impair any sort of trust or confidence between the banker and the prospective borrower.

Preparing bank loan documentation

The process of applying for a loan involves the collection and submission of a large amount of documentation about your business and yourself. The documents required usually depends upon the purpose of the loan, and whether your business is a startup or an already-existing company.

Documentation for startups

A bank will typically request, at a minimum, the following documentation for a startup business:

• A personal financial statement and personal federal income tax returns from the last one to three years
• Projected startup cost estimates
• Projected balance sheets and income statements for at least two years
• Projected cash flow statement for at least the first 12 months
• Evidence of ownership interests in assets, such as leases and contracts, and collateral
• A business plan that includes a narrative explaining the specific use for the requested funds, how the money will assist the business and how the borrowed funds will be repaid (repayment sources and duration of repayment period), including identifying any assumptions used in developing your projected financial
• A personal resume, or at least a written explanation of your relevant past business experience
• Letters of reference recommending you as a reputable and reliable business person may also help your chances for a loan approval

Some lenders will also want you to submit a breakeven analysis in the form of a financial statement or a graph. A breakeven analysis shows the point at which the company's expenses will match the sales or service volume. The breakeven point can be expressed in terms of dollars or units sold.

Tools to use

The Tools & Forms section contains a sample personal financial statement that is typical of the kind of documentation you'll need to complete as part of your loan application package. We also provide Excel spreadsheet templates that allow you to create your own balance sheets, income statements and cash flow budgets. Because these files are in template form, you can customize them and use them over and over again.

Documentation for existing businesses

For an existing business, you can anticipate a request to produce:

• Income statements and business balance sheets for the past three years
• Projected balance sheets and income statements for two years
• Projected cash flow statements for at least the next 12 months
• Personal and business tax returns for the last three years

A business plan, depending upon the credit history of your business and the purpose for the loan, may be unnecessary, and a brief narrative of your intentions may suffice

Additional documentation requests to expect

Depending upon the specific type of loan you are seeking, you should also address certain issues germane to that loan type.

For instance, if money is requested for working capital, your documentation should include:

• The amount that will be used for accounts payable, along with an accounts receivable aging report to disclose the current amounts overdue 30 to 60 days or older
• The amounts that will be used for inventory and any increase in the number of days that inventory on hand will be held
• The amount your cash balances will be increased
• A contingency amount that is equal to at least 10 percent but preferably 25 percent.

If money is needed for machinery or equipment, include information that addresses:

• Whether the assets will be immediately available or if a delay is anticipated
• The price of the assets and how installation will be performed
• Whether installation will interfere with current production and the cost of any interruptions

Documentation for an acquisition of land financing should include the real estate's cost, location and size, intended use, and whether any of the land is for future expansion.