You have a great idea for a business and are ready to put in some hard work. Or maybe you’ve already started a small business, and now you need funding to reach your company’s full potential. Applying for a loan can be intimidating, even to the most seasoned of entrepreneurs. In this article, we’ll walk you through information and terminology you’ll need to know, with the goal of giving you the confidence to talk about finances with a lender – or understand the next steps needed to strengthen your financial plan before seeking funding.
How strong is your business plan?
Most people think business plans are only for start-ups, but even longtime business owners need to maintain and follow a plan.
Your business plan is the foundation of your whole enterprise, so it should be strong. Learn your industry well: your market, potential for growth, the competition, and the best practices of similar businesses. You don’t need a business degree, but doing your homework before writing or re-writing a business plan will give you a better shot at success.
Whether you’re a start-up or you’ve been in business for a few years, your financial plan must indicate that you’ll be able to repay the loan. Two elements to consider are:
Revenue projections: realistic estimations of the money you will earn compared to the money you will spend are a crucial component of a business plan. For example, how many units of your products or services do you have to sell to generate enough sales to cover your operational costs?
Debt-to-service ratio: This is a way to calculate your business’ ability to repay a loan. Lenders may have various requirements in this area. For instance, many lenders require your business’ net income (how much your business makes after paying off all expenses) to be at least 20% more than needed to pay your debts – or a “1.20 debt-to-service-ratio.” For example, if you had an annual loan payment of $10,000, your business’s net income would need to be at least $10,000 to have a 1.00 ratio, and $12,000 in net income would give you a debt-to-service ratio of 1.20, the minimum debt-to-service ratio you’d need for a loan.
By applying these financial concepts, you can determine the maximum loan your business can feasibly take out.
Lenders, like ECDI, may require you to show equity (how much you have saved for your business as well as the amount of money you’ve already invested) or offer collateral (an asset you own, such as equipment, a house, or a car, which you can give the lender to repay the debt if you are unable to make your loan payments). Lenders will have different requirements, depending on the lender and the circumstance.
Are your finances in order?
Prepare now to get these financial components in place.
Business-specific bank account: Do you have a separate bank account for your business? If not, open one now. Not only will keeping your personal and business finances separate spare you from accounting headaches down the road, but a business account is required to apply for most business loans.
Tax records: Even if you’ve been in business awhile, make sure you’re up to date on filing your personal taxes and can access your tax information easily. If your business has operated long enough to have filed taxes, make sure to have at least three years of records on hand.
Understanding your financial health: You don’t need millions in the bank to get a small business loan. If you have a few credit issues, make sure to communicate your plan of action and show steps taken with your lender. You don’t need perfect credit or even excellent credit, but you do need to understand your financial health and credit history and be able to speak about them.
Financial records: Established businesses must show their balance sheet, profit and loss statement, and accounts receivable/accounts payable record, if applicable.
Documentation: Lenders require various documentation to apply for a loan. This includes personal and business records. Click here to view ECDI’s checklist to get a general idea of what you’ll need.
Do You Understand Loan Basics?
If you’ve ever bought a car or home, you are likely familiar with a basic loan processes and terminology. Small business loans have some notable differences (such as the time you can expect it to take for your loan to close, and the need for equity) but use the same terminologies.
Principal: the outstanding amount of your loan, excluding interest or other fees.
Interest rates: the percentage of the loan amount your lender charges over a specific time. Interest rate structures can vary by lender. ECDI uses a simple interest rate structure. For instance, if you got a $10,000 loan with a 6% interest, you would owe a total of $10,600, or $10,000 + ($10,000 x 0.06).
Repayment terms: the amount you must pay back and the specified time you have to do it. This includes number and frequency of installments, meaning how many payments you’ll need to make and how often you’ll need to make them.
Closing fees: an amount you must pay when you receive your loan to cover the cost of the lender’s work and time. Your closing fees pay for the administrative work of underwriting the loan, and the cost of any third-party expenses, such as appraisals.
The five Cs: the criteria a lender uses to decide how likely you will repay or default on your loan. Lenders use these factors to determine if you’ll receive the loan or not, how high your interest rate will be, and any other repayment conditions of your loan.
- Character: your professional or work background, past financial activity, and credit score.
- Pro tip: Traditional lenders tend to place the most emphasis on your financial activity and credit score, while a community lender like ECDI places more emphasis on your actual character as an individual. For example, are you a great chef with a solid business plan and a history of running successful restaurants? Community lenders will take those individual traits into consideration, while a traditional lender may consider a restaurant too high of a risk for a loan, or may have a high threshold for a borrower’s credit score.
- Capital: your personal savings, investments, and assets you’re willing to put toward your loan.
- Capacity: your ability to repay the loan and interest.
- Collateral: the assets you own that you can offer as payment if you default.
- Conditions: the terms of your loan. Conditions include how long you have to repay and any additional actions you must take to close on the loan, such as financial training or repaying debt on your record.
What happens if a business owner defaults on a loan?
You must repay a business loan as stated in your terms to avoid default. Defaulting on a business loan can result in a significant hit to your personal credit and even seizure of your personal assets and property. Monitoring your financial health is one way to reduce your risk of defaulting. This includes keeping good records, calculating expenses against profit, and allowing some flexibility in your business plan to address challenges as they arise.
Most importantly, monitoring will let you take corrective action if you see a problem on the horizon. Discussing potential issues with your lender may seem like a last resort, but your lender wants you to avoid default as much as you do. They are invested in you and can help before issues become a major problem. Sometimes your lender can help you restructure your loan or defer payments to avoid default.
What are your funding options?
Entrepreneurs have lots of choices when it comes to small business funding. Take time to research which type of lender would best suit you and your business.
These are just a few types of funding sources you might use:
- Bank financing: a typical credit extension from a financial institution to cover your business expenses with flexible repayment options.
- SBA financing: government-backed funding programs for small businesses from the Small Business Administration (SBA).
- Community-based organizations: local and state Economic Development Organizations, Community Development Corporations, Community Development Financial Institutions, and Small Business Incubators/Accelerators. These community or non-profit entities can often leverage financing programs and options outside the scope of traditional bank financing. ECDI, for example, partners with banks, the SBA, and other organizations to administer microloans, among other types of loans.
- Bootstrapping: using resources available to you, such as savings or money from friends and family. This can mean little to no debt borrowed and no equity positions in your company given up. Other bootstrapping options include factoring, trade credit, customers, and leasing.
- Other options include crowdfunding, venture capital, and Fin-Tech financing.
Loans can be a complex subject. Educating yourself about your options is crucial. If these options seem overwhelming, know that you aren’t alone. Organizations, such as ECDI or your local SBA office, can help small business owners with accounting, legal advice, networking, marketing, and more, to help them prepare for lending. The more of these resources you use, the more likely you and your business are to be loan-ready, secure a loan, repay it, and thrive.
This mutli-part sponsored series highlighting ECDI’s work in Columbus is presented with paid support by ECDI.
Since 2004, ECDI has assisted Ohio’s entrepreneurs through its one-stop shop business services model, suited to meet the needs of all entrepreneurs, regardless of what business stage they’re in. From providing capital to entrepreneurs looking to expand their businesses, to providing focused, business-specific educational opportunities to enhance entrepreneurial skill sets, ECDI works with their clients to meet their unique needs. Whether assisting a new client with a business concept or an accomplished entrepreneur opening a fifth location, ECDI’s “never say no” approach has allowed over twelve thousand entrepreneurs to take advantage of the services it provides. Visit ecdi.org today to learn more.