What is your borrowing potential?

by James Kunkel, Executive Director

OK, you've prepared your business plan. You have conducted clear, objective research and identified your primary target market. You have measured it demographically and can logically demonstrate a need for your product or service. You have even assembled some financial projections for your friendly banker. She certainly knows your company's deposit activity and always sounds encouraging. When you spoke with her on the phone yesterday, she said she'd be delighted to listen to your proposal. Everything is going according to plan. So why then do you feel so unsure about this loan request?

Sound familiar? Don't feel bad. At one time or another just about every small business owner has experienced the uncertainty of commercial financing. Granted, it's not the kind of thing you do every day. Nevertheless, as a moderately successful small business owner, you would think there might be some better way of knowing if you have the ability to secure outside financing. The good news is that there are some practical rules of thumb that can determine just how realistic obtaining a commercial loan is for your business.

Commercial lending is a heavily regulated industry. You won't be afforded the same luxuries in the decision-making process that you would in an automotive or home equity loan application. Business plans, financial projections, income tax returns and reams of supporting documentation are often the norm. Why? Well, regardless of any individual bank's willingness to lend, their primary goal is increasing shareholder value. Consequently, banks tend to be risk-averse and shy away from any ventures that might have a negative impact on the bank's portfolio. Combine that mentality with the discomforting fact that most new small businesses don't survive beyond their third year. This is why commercial borrowing can appear so frustrating. However, it's not all bad news. Banks are in the business of lending money, and good banks want to make good loans. The key is to structure loans that are good for both you and the bank.

The first thing to consider when evaluating your borrowing potential is how much money you really need. This involves determining where your capital is to be used and how it will work for your company. Stay away from guessing. Whenever possible, try to use real numbers. The Sources and Uses statement can be a helpful tool. As the name implies, a Sources and Uses statement simply ranks individual funding sources and their respective terms and rates. This amount is then matched against the planned allocation of those dollars. The totals of the two categories should be equal. Use the Sources and Uses statement to measure your total capital requirements and determine where that capital will come from.

What happens if you don't know how much to borrow? You might know how much you would like to acquire, but how do you know if this figure is realistic? Every business, and every individual for that matter, has a certain level of debt that they can comfortably sustain. This is known as borrowing capacity. Even though there are many considerations that eventually enter into the approval process, there are two measures that can quickly help you determine your company's capacity to borrow. By understanding the nature of sufficient equity and adequate collateral, you can readily refine your loan request into parameters that meet most banks' expectations.

Equity is defined as the contribution advanced by the principles of the business toward the total project costs of any given loan package. Translation: 100 percent debt financing is highly unlikely, if not impossible. Lenders will expect you to absorb a portion of the credit risk. Occasionally, you can incorporate government lending programs into your loan package to reduce, but not eliminate, the amount of your equity injection. Nevertheless, most credible financing packages will still require some equity investment on your part.

You should plan on injecting a minimum of 20 percent of total project costs into the loan package. Beware, however, that for businesses operating in what are considered high-risk industries, you may be asked to contribute 25 percent, 30 percent or even 40 percent. This is especially true in high-turnover industries such as bars and restaurants. You should also be aware that cash is undoubtedly the best form of equity. Start-up ventures can generally leverage only cash. On the other hand, existing businesses that reflect significant equity on their balance sheet often discover that this equity is not liquid. Their discretionary cash has already been spent to purchase equipment or inventory, subsequently reducing their ability to borrow.

Another way of calculating your capacity is by looking at your projected debt-to-worth ratio. This ratio expresses the relationship between capital contributed by creditors and that contributed by owners. The lower the ratio, the greater the proportion of total capital that is invested, not borrowed, by the owners. A high ratio reflects greater financial leverage, which means increased financial risk. Companies with a high degree of leverage may not be able to survive economic downturns as readily as their competitors who are operating with less debt.

To compute your debt-to-worth ratio, divide your projected total liabilities by your tangible net worth. Although banks generally like to see a ratio of 4-to-1 or lower, this figure can vary widely from industry to industry. Visit your local Small Business Development Center, and ask them for a copy of the Robert Morris and Associates (RMA) Annual Statement Studies. This yearly publication collects financial data from a broad range of industries and compiles it into industry averages. By comparing your capital structure against the industry norm, you can develop a strong sense of the acceptable level of debt you should be considering.

Adequate collateral is another necessary ingredient for any good loan package. Bankers want to know how they will get paid if you are not able to make your payments. Collateral addresses this concern. It is security pledged toward the repayment of a loan. If for some reason you don't pay, the bank can offset its losses by liquidating collateral. Furthermore, not only will the bank want to secure the assets of the business, in many cases they will expect you to pledge your personal assets, as well.

The thing to remember when evaluating collateral is that the value you place on a particular asset is not the same value the bank will place on it. The bank determines the loan value of your assets based on what they could receive for them by selling them in a hurry. Consequently, the inventory that you think is so valuable may only be worth 50 cents on the dollar to your friendly banker. Specialized, custom-built equipment that you are paying a premium for may be of extreme value to you; but from a liquidation perspective, it's hardly that attractive. Despite the holding power of real estate, it only generates 70 to 80 cents on the dollar, at best.

Before you approach a potential funding source, calculate what you can provide in the way of collateral. Figure 60 percent to 80 percent of your appraised real estate holdings, less any mortgages or liens. Look at your company's equipment and consider its resell value. Factor in obsolescence, the condition of the equipment, even the degree of specialization. How much is it really worth on the open market? When considering inventory, look at how marketable the product is. Is it seasonal or perishable? Is it a consumer good that may be readily exchanged, or does it have value only to a specialized industry with few buyers? Examine the quality of your accounts receivables? Look at the "agings" of your receivables. Do you have any more than 90 days? Do you have any uncollectable accounts? Those won't qualify as adequate collateral. Better to allow 65 to 85 cents on the dollar for only those receivables under 60 days.

Collateral can also come from sources other than your own assets. Assets such as real estate, stocks and bonds, or CDs pledged by co-signers frequently serve as adequate collateral. On occasion, some banks will use signed contracts and purchase orders as collateral. Moreover, many government lending programs, especially the SBA's Low Documentation (LowDoc) program, maintain that a lack of collateral is specifically not a deterrent to obtaining an SBA loan guarantee.

Knowing that you have sufficient equity and adequate collateral can greatly increase the probability of obtaining commercial financing. However, it does not guarantee that the loan will be approved. All businesses should be prepared to provide additional supporting documentation to their lender. They should also be keenly aware of the impact new debt has on their cash flow. View the tools described above as simply a first step in deciding at what level external financing should be pursued.