Over the years, many have predicted that large banks, regional banks and alternative lenders would approve more small-business loans. It was news that may have been encouraging for any small-business owner thinking about applying for a bank loan.
After much optimism, however, recent data reports that this percentage has not changed much. According to the Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices April report, lenders have slightly tightened their standards for small businesses (defined as businesses with less than $50 million in annual revenue over the past three quarters).
Yes, even though we are nine years past the start of the Great Recession, banks still have tightened standards for small businesses. Despite the tightening, some owners are flocking to traditional sources given the increased scrutiny to online lenders.
But is it possible for small-business owners to overcome the rejection hurdle that comes with applying for a bank loan, and better position their business’ chance of getting approved for a loan?
According to Ricardo Devallon, deputy director of New York City’s Business Solutions, the answer depends on which financial institution is evaluating you. Devallon asserts that “each bank, CDFI (Community Development Financial Institution), SBA lender or alternative financier has their own processes and lending standards.”
The group that Devallon leads directly helps small-business owners navigate the plethora of financing options in the market. Instead of focusing on why most businesses get rejected by lending providers, Devallon focuses on the factors that lead to loan approvals. Amongst these factors are what's known as the “5 Cs of Credit”—a concept not unique to Devallon, and worthy of explanation as you begin applying for a bank loan:
Most owners are familiar with collateral because it sometimes means that an owner pledges a personal asset, such as a home, to the lender with the agreement that it will be the repayment source in case one can't repay the loan. Business assets such as real estate, equipment and working capital (e.g., account receivables and inventory) may also be pledged as a security against default.
Cited as one of the most important of the factors, capacity reflects whether a borrower can handle their debt payments, both on a retrospective and prospective basis. The lender also considers the cash flow from the business, the timing of the repayment and the probability of successful repayment of the loan.
Upon my interviews with many traditional banks, one key capacity metric is the debt service coverage ratio, defined as how much of a business’s operating income will cover a debt payment. A debt coverage ratio above 1.25 is considered “safe” amongst many traditional lenders.
When an owner invests his or her personal money in the business, banks view this shared interest as capital. It is important for banks to know how much the owner also has at risk, particularly if something goes wrong. Lenders may prefer when an owner has a meaningful amount of personal capital committed relative to the requested loan size. If an owner asks for a $200,000 loan, but only has $10,000 (or 5 percent) of personal capital committed, a lender may not be as welcoming.
As one of the most subjective credit measures, character simply reflects a combination of your personal credit history, reputation, years of business experience and/or educational background. A personal credit score may have a significant impact on the approval process; lower credit scores are usually associated with denied applications or higher interest rates if approved on a loan application.
Lenders often consider local economic conditions, the competitive environment and sector-specific conditions that may affect the business. In evaluating these “conditions,” lenders also examine how the loan proceeds will be used within the business, whether for working capital, additional equipment or inventory.
As a result, business owners may want to be aware of the specifics for each of the “5 Cs of Credit” factors of the particular institution they approach for financing. Remember, however, that many lenders are inherently risk-averse toward small businesses because these ventures may be considered in the early part of their business lifecycle. In the Harvard Business School report, “The State of Small Business Lending: Credit Access during the Recovery and How Technology May Change the Game," former Small Business Administration administrator Karen Gordon Mills points to the information asymmetry problem that can lead to problems with assessing creditworthiness.
With the closing of community banks in recent years, which traditionally placed greater emphasis on relationships with borrowers in their underwriting processes, it may be even more advisable for business owners to have an understanding of what banks are using to evaluate their loan applications.
But, armed with an understanding of the “5 Cs of Credit,” one may be able to better prepare as they begin applying for a bank loan and move forward in the loan approval process.
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