Understanding why lenders make it so difficult for small businesses to get financing can help business owners better prepare to navigate through the borrowing process and improve their chances of success. From a borrower’s perspective, lenders require too much information, which takes a lot of time and money to gather. The lenders, on the other hand, perceive lending to small businesses as a high risk, so they need to mitigate those risks by performing extensive due diligence and attaching performance conditions to approved loans. Read more to learn how to secure a small business loan.
Why Lenders Don’t Like Risk
Lenders are not in the business of taking high risks, losing money, repossessing businesses and taking on costly legal battles. Lenders are in the business of making money and mitigating risks of loss. Once loans are approved and funded, lenders have little or no control over how you spend the borrowed money and run business operations. They don’t get to share in the rewards when you are doing well. They do, however, risk losing some or all of their investment if your business fails. Given this dilemma, banks resort to extensive preapproval risk analysis and imposition of post approval performance conditions.
In short, lenders safeguard against what are known as “adverse selection” and “moral hazard” in the financial world. Adverse selection refers to the risks of lending money to an unworthy business or debtors. Lenders guard against this risk by performing pre-approval due diligence. Moral hazard refers to the possibility that the borrower will not use borrowed funds for their intended purpose, or, will fail to execute on a business plan that they proposed to secure funding. Lenders guard against moral hazard by imposing certain financial and operational performance requirements such as maintenance of a minimum debt service ratio, net working capital or inventory level until the loan is paid off. In the industry, these performance conditions are known as restrictive covenants.
If you understand that the lenders are risk averse – just by the very nature of their business, it can help your small business better prepare to court financers for loans.
When Small Businesses Default on Loans – Everyone Loses
Perhaps an example will help clarify a few things about why lenders require borrowers to meet tough requirements.
The following simplified scenario will illustrate the ripple effect resulting from an unpaid loan. Assume a lender loans $20,000 at 10% interest per annum and the business defaults on the loan. Now, the lender has to recoup the loss when making new loans. If another business attempts to secure a loan for $200K, not only does the lender have all the risks and costs associated with the new loan, but they also have to attempt to earn back the lost $20,000. In addition to this, the lender would be under pressure to pay some sort of return to investors who funded the loan in the first place. All of these extra burdens on the new $200K loan would make the terms (interest rates and performance conditions) non-competitive. If many businesses default on loans, lenders would eventually go out of business. So you can see the why lenders are so protective, and why they insist on stringent due diligence and performance terms. In the lending business, defaulting loans have an exponential negative affect on future loans. Lenders do not want to be chasing old bad loans, nor do they want to pass some of the burden to future loan recipients. If they do, rates increase, rules become tougher, and fewer people will seek financing. The lenders lose, and, businesses lose, too.
Flareapps.com small business tip #036The 5 Cs of Credit – Questions to Ask Yourself When Seeking Financing
When lenders are considering whether a prospective borrower is a risk, they may apply a risk assessment guideline known as the “5 Cs”, namely: Character, Capacity, Capital, Collateral, and Conditions. Before you seek financing, applying typical “5 C” questions to your business can help ensure you will meet the scrutiny of financers.
- Is this a new business or an established business with a proven track record? If it is an established business, how much cash does the business generates each year? Does it have a solid track record of profitability? If it’s a new business, is the business plan credible and realistic?
- Why do you need to borrow? Is your business wanting to fund working capital, buy equipment or facility, buy a new business, increase marketing efforts, or cover operating loss? Do your reasons for needing a loan make good economic sense?
- How much debt can your business service? Will your business generate enough cash from operations to service the loan? How much are you paying to cover current debts, and how much additional debt can your business service? What type of loan do you need: short term or long-term? Is your business’s debt to equity ratio in line with the industry average?
- How will you repay the loan and interest: from future profitability and cash flow? Will your business generate enough cash to repay the loan when payments are due? Can your operation’s cash inflow match the timing of loan repayment?
- Are you credit worthy? Can you offer any collateral or third-party guarantees? Does the business, and its owners have an excellent credit history?
- Does your management team have a proven track record? Can they successfully execute the proposed business plan? Are they capable of making prudent decisions and address known and new operational and competitive challenges?
- Does the business have a strong culture of financial discipline? Is it run on reliable financial and business management processes? Does management prepare yearly financial and operating budgets, monitor performance and proactively manage deviation from planned results?
- Is your business in a growing or declining industry? How profitable and competitive is the industry? Are you in an industry that does business in “cash”? Are you looking for money in a growing or declining economy?
How Flare Can Help You Impress a Loan Officer
Now that you know what lenders look for and why, you can improve your loan pitch and implement changes that lead to a successful loan application. You can take few simple steps to demonstrate your ability to manage business performance and finance. If you are currently managing business finances on paper or in various spreadsheets, or perhaps not managing them at all, this will hurt your chances of securing a loan. If, however, you track your income, expenses and profit, use budgeting tools and financial reports to manage finances and plan for financial growth, your chances of securing a loan increase dramatically. This is where Flare can help.
Not only does Flare give you the tools you’ll require every day, such as online invoicing, estimates, and automated bank transaction reconciliation, it provides you with easy-to-use business financial management tools, too! By using Flare’s intuitive business budgeting and with Flare’s full suite of financial reports, when you are seeking a loan, you’ll be able to provide financers the information they need to make a decision. The great thing is that you don’t need to be a financial management expert to use Flare. While you are going about the daily business of invoicing and recording expenses, in the background Flare is creating financial reports in real time. Having and using Flare’s budgeting feature, and supplying professional reports will show a lender that you are diligent and serious about your business.
As the saying goes “You don’t get a second chance to make a first impression”. With Flare, the first impression you make may mean the difference between getting that loan or being rejected.
A Little Knowledge and Flare Can Help