What do Lenders Look at when Evaluating my Business for a Loan?
We’ve been told with uncharacteristic bluntness from lenders – particularly alternative financing lenders – that demand for loans remains high right now. For example, most lenders today will charge a fee to take a loan application.
“Today, with lenders, they’re not going to do the due diligence without a fee,” William Morgenstein, president of Florida-based financial services firm Marquesa Funding. “They’re inundated as it is. They’re not going to do it without getting paid for the underwriting.”
Firms like Marquesa, which deal in alternative financing for small and medium sized businesses, have no shortage of applicants these days, he said.
On some level, even as borrowers are weeding out lenders, the lenders find themselves weeding out borrowers. For Morgenstein, a few questions can immediately eliminate a potential client. “Misstatements. Checking out facts, asking someone what their credit rating is,” he said. “You’ll ask someone what their credit rating is and they won’t know or will tell you something vague – a good broker will sense something that isn’t forthcoming and you have to drop that right away.”
Experience is a second factor, he said. “They go into business, but they have no background for it,” Morgenstein said. “They might be good at certain parts of it but don’t have the business background – the lenders today won’t go for that at all.”
Morgenstein also likes to see some skin in the game – financial evidence that a borrower stands to gain from the business, and has something tangible to lose if the business doesn’t perform. Lenders are also looking very hard at cash flow, he said. “They’re less worried about the (profit and loss) statement. More important is the cash flow statement.”
Below, we’ve listed the most common factors cited in lenders’ decisions to offer credit to a business.
Your business’ credit
Lenders will review your firm’s credit rating with Experian, Dun & Bradstreet and other rating agencies, to see who you are doing business with, how long you’ve been in business, your company’s payment record, and how much debt you’re carrying. Experian releases a monthly report describing credit and payment patterns in the US.
Different credit rating agencies use different models, of course. According to Experian, firms with delinquent accounts are an average of 6.3 days beyond terms. About 12.7 percent of their accounts payable are delinquent and about 5.7 percent are more than 90 days late. If your company is performing worse than this, you’re in the bottom half of the lending pool.
Here’s a sense of how lenders view your credit score, from one of our partners, OnDeck Capital. OnDeck has a tool to help businesses determine what kind of credit they can obtain.
Particularly true with alternative lenders, your personal credit record can be a flag for a loan to your business. If you’re having trouble making payments on your own debts – late car payments, mortgage payments, student loans or credit cards – then lenders may believe that you might allow your business loans to default before your personal loans. Oddly enough, the evidence appears to be exactly the opposite: a recent Experian presenter noted that business owners more often allow their personal loans to default before their business loans, possibly because many business owners would rather take a hit on their own credit than jeopardize their source of income. Credit scores below 680 are considered subprime, and will probably take you out of consideration for an SBA loan.
Different kinds of lenders will appraise the value of your collateral differently. Conventional lenders can make judgments about the value of your business and its assets based on the present value of its future cash flow. Hard money lenders are far more interested in the straight sale value of your property, and typically lend at a lower loan to value rate than conventional lenders.
Loan to Value Ratio
LTV Ratio is the amount you plan to borrow, divided by the value of the thing you plan to purchase. If you’re buying property, or a business, then that value is used in the denominator. If you’re borrowing money to finance working capital, then this calculation become more complicated, and some lenders will throw it out entirely, in favor of a different ratio. Most conventional lenders will require a loan to capital ratio under 60 to 70 percent. SBA loans allow for much higher values, up to 100 percent.
This is a similar consideration to collateral. Lenders want to know that the borrower has “skin in the game,” or that the borrower serves to benefit from the transaction.
Only predatory lenders will want to make a loan that hurts a client more than it helps. Cash flow is a yardstick. Put simply, a lender wants to know that you’ll be making more money with a loan than without it. It’s another way of looking at your skin in the game. If your company lacks the cash flow to pay off the loan, you may not be a candidate for that kind of loan.
Debt Coverage Ratio
The DCR is Net Operating Income divided by your annual loan payment, and represents the amount of money you can reasonably expect to afford to pay on business loans. Depending on the lender, DCR can be more important than your loan to value. Most lenders are looking for a DCR of 1.2 or better, which is to say, operating income at least 20 percent greater than your total debt burden. Expect to have to justify your income and expense projections with some rigor.
Normally, shopping around widely for a good loan makes perfect sense. Not so for business loans. Potential loan clients have inundated lenders with competitive offerings. When a lender does a credit check on an application, that lender can see a record of all the other credit checks that other lenders have performed, regardless of whether a loan was approved or denied. Lenders tell us that seeing multiple credit checks by their competitors is a red flag – it’s an indication that the client may have been turned down during the diligence process by other lenders.
Lenders view the following signs as red flags:
- Over-borrowing or under-borrowing.
- A change in ownership.
- A weak or inexperienced management team.
- Aggressive tax management on financial statements.
- Multiple business incorporations by the same owner in different states.
- No fixed address for the business.
- A weak or nonexistent business plan.
- A lack of references.
- An effective tax rate far below the industry standard
- Improper or aggressive capitalization of expenses.
- Lying to your broker or lender about your credit score before a credit check.
- Writing off personal expenses as business expenses.
- Selling off property or equipment without adequate explanation.
- Allowing property or equipment to become fully depreciated without capital expenditures to replace the losses.
- An unexplained slowdown in your company’s cash cycle or operating cycle.