Summary
Some
small business persons cannot understand why a lending
institution
refused to lend them money. Others have no trouble
getting
funds, but they are surprised to find strings attached
to
their loans. Such owner-managers full to realized that banks
and
other lenders have to operate by certain principles just as
do
other types of business.
This
Aid discusses the following fundamentals of borrowing:
(1)
credit worthiness, (2) kinds of loans, (3) amount of money
needed,
(4) collateral, (5) loan restrictions and limitations,
(6)
the loan application, and (7) standards which the lender
uses
to evaluate the application.
Introduction
Inexperience
with borrowing procedures often creates resentment
and
bitterness. The stories of three small business persons illustrate
this
point.
"I'll
never trade here again," Bill Smith said when his bank refused
to
grant him a loan. "I'd like to let you have it, Bill," the banker
said,
"but your firm isn't earning enough to meet your current
obligations."
Mr. Smith was unaware of a vital financial fact,
namely,
that lending institutions have to be certain that the
borrower's
business can repay the loan.
Tom
Jones lost his temper when the bank refused him a loan because he
did
not know what kind or how much money he needed. "We hesitate to
lend,"
the banker said, "to business owners with such vague ideas of
what
and how much they need."
John
Williams' case was somewhat different. He didn't explode until
after
he got the loan. When the papers were ready to sign, he realized
that
the loan agreement put certain limitations on his business
activities.
"You can't dictate to me," he said and walked out of the
bank.
What he didn't realize was that the limitations were for his good
as
well as for the bank's protection.
Knowledge
of the financial facts of business life could have saved
all
three the embarrassment of losing their tempers. Even more
important,
such information would have helped them to borrow money
at
a time when their businesses needed it badly.
This
Aid is designed to give the highlights of what is involved
in
sound business borrowing. It should be helpful to those who
have
little or no experience with borrowing. More experienced
owner-managers
should find it useful in re-evaluating their
borrowing
operations.
Is
Your Firm Credit Worthy?
The
ability to obtain money when you need it is as necessary to
the
operation of your business as is a good location or the right
equipment,
reliable sources of supplies and materials, or an adequate
labor
force.
Before
a bank or any other lending agency will lend you money, the
loan
officer must feel satisfied with the answers to the five
following
questions:
1.
What sort of person are you, the prospective borrower? By all
odds,
the character of the borrower comes first. Next is your ability
to
manage your business.
2.
What are you going to do with the money? The answer to this
question
will determine the type of loan, short or long-term. Money
to
be used for the purchase of seasonal inventory will require
quicker
repayment than money used to buy fixed assets.
3.
When and how do you plan to pay it back? Your banker's judgment
of
your business ability and the type of loan will be a deciding
factor
in the answer to this question.
4.
Is the cushion in the loan large enough? In other words, does
the
amount requested make suitable allowance for unexpected
developments?
The banker decides this question on the basis of
your
financial statement which sets forth the condition of your
business
and on the collateral pledged.
5.
What is the outlook for business in general and for your business
particularly?
Adequate
Financial Data is a "Must."
The
banker wants to make loans to businesses which are solvent,
profitable,
and growing. The two basic financial statements used to
determine
those conditions are the balance sheet and profit-and-loss
statement.
The former is the major yardstick for solvency and the
latter
for profits. A continuous series of these two statements
over
a period of time is the principal device for measuring
financial
stability and growth potential.
In
interviewing loan applicants and in studying their records, the
banker
is especially interested in the following facts and figures.
General
Information: Are the books and records up-to-date and in
good
condition? What is the condition of accounts payable? Of
notes
payable?
What
are the salaries of the owner-manager and other company officers?
Are
all taxes being paid currently? What is the order backlog? What
is
the number of employees? What is the insurance coverage?
Accounts
Receivable: Are there indications that some of the
accounts
receivable have already been pledged to another creditor?
What
is the accounts receivable turnover? Is the accounts
receivable
total weakened because many customers are far behind
in
their payments? Has a large enough reserve been set up to
cover
doubtful accounts? How much do the largest accounts owe and
what
percentage of your total accounts does this amount represent?
Inventories:
Is merchandise in good shape or will it have to be
marked
down? How much raw material is on hand? How much work
is
in process? How much of the inventory is finished goods?
Is
there any obsolete inventory? Has an excessive amount of
inventory
been consigned to customers? Is inventory turnover in
line
with the turnover for other businesses in the same industry?
Or
is money being tied up too long in inventory?
Fixed
Assets: What is the type, age, and condition of the
equipment?
What are the depreciation policies? What are
the
details of mortgages or conditional sales contracts?
What
are the future acquisition plans?
What
Kind of Money?
When
you set out to borrow money for your firm, it is important to
know
the kind of money you need from a bank or other lending
institution.
There are three kinds of money: short term, term
money,
and equity capital.
Keep
in mind that the purpose for which the funds are to be used is
an
important factor in deciding the kind of money needed. But even
so,
deciding what kind of money to use is not always easy. It is
sometimes
complicated by the fact that you may be using some of
the
various kinds of money at the same time and for identical
purposes.
Keep
in mind that a very important distinction between the types of
money
is the source of repayment. Generally, short-term loans are
repaid
from the liquidation of current assets which they have
financed.
Long-term loans are usually repaid from earnings.
Short-Term
Bank Loans
You
can use short-term bank loans for purposes such as financing
accounts
receivable for, say 30 to 60 days. Or you can use them
for
purposes that take longer to pay off--such as for building
a
seasonal inventory over a period of 5 to 6 months. Usually,
lenders
expect short-term loans to be repaid after their
purposes
have been served: for example, accounts receivable
loans,
when the outstanding accounts have been paid by the
borrower's
customers, and inventory loans, when the inventory
has
been converted into saleable merchandise.
Banks
grant such money either on your general credit reputation
with
an unsecured loan or on a secured loan.
The
unsecured loan is the most frequently used form of bank credit
for
short-term purposes. You do not have to put up collateral
because
the bank relies on your credit reputation.
The
secured loan involves a pledge of some or all of your assets.
The
bank requires security as a protection for its depositors
against
the risks that are involved even in business situations
where
the chances of success are good.
Term
Borrowing
Term
borrowing provides money you plan to pay back over a fairly
long
time. Some people break it down into two
forms: (1)
intermediate--loans
longer than 1 year but less than 5 years,
and
(2) long-term--loans for more than 5 years.
However,
for your purpose of matching the kind of money to the
needs
of your company, think of term borrowing as a kind of money
which
you probably will pay back in periodic installments from
earnings.
Equity
Capital
Some
people confuse term borrowing and equity (or investment) capital.
Yet
there is a big difference. You don't have to repay equity money.
It
is money you get by selling a part interest in your business.
You
take people into your company who are willing to risk their money
in
it. They are interested in potential income rather than in an
immediate
return on their investment.
How
Much Money?
The
amount of money you need to borrow depends on the purpose for
which
you need funds. Figuring the amount of money required for
business
construction, conversion, or expansion--term loans or
equity
capital--is relatively easy. Equipment manufacturers,
architects,
and builders will readily supply you with cost
estimates.
On the other hand, the amount of working capital you
need
depends upon the type of business you're in. While rule-of-
thumb
ratios may be helpful as a starting point, a detailed projection
of
sources and uses of funds over some future period of time--
usually
for 12 months--is a better approach. In this way, the
characteristics
of the particular situation can be taken into
account.
Such a projection is developed through the combination
of
a predicted budget and a cash forecast.
The
budget is based on recent operating experience plus your best
judgment
of performance during the coming period. The cash forecast
is
your estimates of cash receipts and disbursements during the
budget
period. Thus, the budget and the cash
forecast together
represent
your plan for meeting your working capital requirements.
To
plan your working capital requirements, it is important to know
the
"cash flow" which your business will generate. This involves
simply
a consideration of all elements of cash receipts and
disbursements
at the time they occur. These elements are listed
in the
profit-and-loss statement which has been adapted to show
cash
flow. They should be projected for each month.
What
Kind of Collateral?
Sometimes,
your signature is the only security the bank needs when
making
a loan. At other times, the bank requires additional
assurance
that the money will be repaid. The kind and amount of
security
depends on the bank and on the borrower's situation.
If
the loan required cannot be justified by the borrower's
financial
statements alone, a pledge of security may bridge the
gap.
The types of security are: endorsers; comaker and guarantors;
assignment
of leases; trust receipts and floor planning; chattel
mortgages;
real estate; accounts receivables; savings accounts;
life
insurance policies; and stocks and bonds. In a substantial
number
of States where the Uniform Commercial Code has been enacted,
paperwork
for recording loan transactions will be greatly simplified.
Endorsers,
Co-makers, and Guarantors
Borrowers
often get other people to sign a note in order to bolster
their
own credit. These endorsers are contingently liable for
the
note they sign. If the borrower fails to pay up, the bank
expects
the endorser to make the note good. Sometimes, the
endorser
may be asked to pledge assets or securities too.
A
co-maker is one who creates an obligation jointly with the
borrower.
In such cases, the bank can collect directly from
either
the maker or the co-maker.
A
guarantor is one who guarantees the payment of a note by signing
a
guaranty commitment. Both private and government lenders often
require
guarantees from officers of corporations in order to
assure
continuity of effective management. Sometimes, a manufacturer
will
act as guarantor for customers.
Assignment
of Leases
The
assigned lease as security is similar to the guarantee. It is
used,
for example, in some franchise situations.
The
bank lends the money on a building and takes a mortgage. Then
the
lease, which the dealer and the parent franchise company work
out,
is assigned so that the bank automatically receives the rent
payments.
In this manner, the bank is guaranteed repayment of
the
loan.
Warehouse
Receipts
Banks
also take commodities as security by lending money on a
warehouse
receipt. Such a receipt is usually delivered directly to
the
bank and shows that the merchandise used as security either has
been
placed in a public warehouse or has been left on your premises
under
the control of one of your employees who is bonded (as in
field
warehousing). Such loans are generally made on staple or
standard
merchandise which can be readily marketed. The typical
warehouse
receipt loan is for a percentage of the estimated value
of
the goods used as security.
Trust
Receipts and Floor Planning
Merchandise,
such as automobiles, appliances, and boats, has to be
displayed
to be sold. The only way many small marketers can afford
such
displays is by borrowing money. Such loans are often secured
by
a note and a trust receipt.
This
trust receipt is the legal paper for floor planning. It is used
for
serial-numbered merchandise. When you sign one, you (1)
acknowledge
receipt of the merchandise, (2) agree to keep the
merchandise
in trust for the bank, and (3) promise to pay the
bank
as you sell the goods.
Chattel
Mortgages
If
you buy equipment such as a cash register or a delivery truck, you
may
want to get a chattel mortgage loan. You give the bank a lien on
the
equipment you are buying.
The
bank also evaluates the present and future market value of the
equipment
being used to secure the loan. How rapidly will it
depreciate? Does the borrower have the necessary fire,
theft,
property
damage, and public liability insurance on the equipment?
The
banker has to be sure that the borrower protects the equipment.
Real
Estate
Real
estate is another form of collateral for long-term loans.
When
taking a real estate mortgage, the bank finds out: (1) the
location
of the real estate, (2) its physical condition, (3) its
foreclosure
value, and (4) the amount of insurance carried on the
property.
Accounts
Receivable
Many
banks lend money on accounts receivable. In effect, you are
counting
on your customers to pay your note.
The
bank may take accounts receivable on a notification or a
nonnotification
plan. Under the notification plan, the purchaser of
the
goods is informed by the bank that his or her account has been
assigned
to it and he or she is asked to pay the bank. Under the
nonnotification
plan, the borrower's customers continue to pay you
the
sums due on their accounts and you pay the bank.
Savings
Accounts
Sometimes,
you might get a loan by assigning to the bank a savings
account. In such cases, the bank gets an assignment
from you and
keeps
your passbook. If you assign an account in another bank as
collateral,
the lending bank asks the other bank to mark its records
to
show that the account is held as collateral.
Life
Insurance
Another
kind of collateral is life insurance. Banks will lend up to
the
cash value of a life insurance policy. You have to assign the
policy
to the bank.
If
the policy is on the life of an executive of a small corporation,
corporate
resolutions must be made authorizing the assignment. Most
insurance
companies allow you to sign the policy back to the original
beneficiary
when the assignment to the bank ends.
Some
people like to use life insurance as collateral rather than borrow
directly
from insurance companies. One reason is that a bank loan is
often
more convenient to obtain and usually may be obtained at a lower
interest
rate.
Stocks
and Bonds
If
you use stocks and bonds as collateral, they must be marketable.
As
a protection against market declines and possible expenses of
liquidation,
banks usually lend no more than 75 percent of the
market
value of high grade stock. On Federal Government or municipal
bonds,
they may be willing to lend 90 percent or more of their
market
value.
The
bank may ask the borrower for additional security or payment
whenever
the market value of the stocks or bonds drops below the
bank's
required margin.
What
Are the Lender's Rules?
Lending
institutions are not just interested in loan repayments.
They
are also interested in borrowers with healthy profit-making
businesses. Therefore, whether or not collateral is
required for
a
loan, they set loan limitations and restrictions to protect
themselves
against unnecessary risk and at the same time against
poor
management practices by their borrowers.
Often some owner/
managers
consider loan limitations a burden.
Yet
others feel that such limitations also offer an opportunity
for
improving their management techniques.
Especially
in making long-term loans, the borrower as well as the
lender
should be thinking of: (1) the net earning power of the
borrowing
company, (2) the capability of its management,
(3)
the long range prospects of the company, and (4) the long
range
prospects of the industry of which the company is a part.
Such
factors often mean that limitations increase as the duration
of
the loan increases.
What
Kinds of Limitations?
The
kinds of limitations, which an owner-manager finds set upon
the
company depends, to a great extent, on the company. If the
company
is a good risk, only minimum limitations need be set. A
poor
risk, of course, is different. Its
limitations should be
greater
than those of a stronger company.
Look
now for a few moments at the kinds of limitations and
restrictions
which the lender may set. Knowing what they are can
help
you see how they affect your operations.
The
limitations which you will usually run into when you
borrow
money are:
(1)
Repayment terms.
(2)
Pledging or the use of security.
(3)
Periodic reporting.
A
loan agreement, as you may already know, is a tailor-made
document
covering, or referring to, all the terms and conditions
of
the loan. With it, the lender does two things: (1) protects
position
as a creditor (keeps that position in as protected a
state
as it was on the date the loan was made) and (2) assures
repayment
according to the terms.
The
lender reasons that the borrower's business should generate
enough
funds to repay the loan while taking care of other needs.
The
lender considers that cash inflow should be great enough to
do
this without hurting the working capital of the borrower.
Covenants--Negative
and Positive
The
actual restrictions in a loan agreement come under a section known
as
covenants. Negative covenants are things which the borrower may not
do
without prior approval from the lender. Some examples are: further
additions
to the borrower's total debt, non-pledge to others of the
borrower's
assets, and issuance of dividends in excess of the terms
of
the loan agreement.
On
the other hand, positive covenants spell out things which the
borrower
must do. Some examples are: (1) maintenance of a minimum
net
working capital. (2) carrying of adequate insurance,
(3)
repaying the loan according to the terms of the agreement,
and
(4) supplying the lender with financial statements and reports.
Overall,
however, loan agreements may be amended from time to time
and
exceptions made. Certain provisions may be waived from one year
to
the next with the consent of the lender.
You
Can Negotiate
Next
time you go to borrow money, thrash out the lending terms before
you
sign. It is good practice no matter how badly you may need the
money.
Ask to see the papers in advance of the loan closing.
Legitimate
lenders are glad to cooperate.
Chances
are that the lender may "give" some on the terms. Keep in mind
also
that, while you're mulling over the terms, you may want to get
the
advice of your associates and outside advisors. In short, try to
get
terms which you know your company can live with. Remember,
however,
that once the terms have been agreed upon and the loan
is
made (or authorized as in the case of SBA), you are bound by them.
The
Loan Application
Now
you have read about the various aspects of the lending process
and
are ready to apply for a loan. Banks and other private lending
institutions,
as well as the Small Business Administration, require
a
loan application on which you list certain information about
your
business.
For
the purposes of explaining a loan application, this Aid uses the
Small
Business Administration's application for a loan (SBA Form 4
not
included). The SBA form is more detailed
than most bank forms.
The
bank has the advantage of prior knowledge of the applicant and
his
or her activities. Since SBA does not
have such knowledge, its
form
is more detailed. Moreover, the longer
maturities of SBA loans
ordinarily
will necessitate more knowledge about the applicant.
Before
you get to the point of filling out a loan application, you
should
have talked with an SBA representative, or perhaps your
accountant
or banker, to make sure that your business is eligible
for
an SBA loan. Because of public policy,
SBA cannot make certain
types
of loans. Nor can it make loans under certain conditions. For
example,
if you can get a loan on reasonable terms from a bank, SBA
cannot
lend you money. The owner-manager is also not eligible for an
SBA
loan if he or she can get funds by selling assets which his or
her
company does not need in order to grow.
When
the SBA representative gives you a loan application, you will
notice
that most of its sections ("Application for Loan"--SBA Form 4)
are
self-explanatory. However, some applicants have trouble with
certain
sections because they do not know where to go to get the
necessary
information.
Section
3--"Collateral Offered" is an example. A company's books
should
show the net value of assets such as business real estate and
business
machinery and equipment. "Net" means what you paid for
such
assets less depreciation.
If
an owner-manager's records do not contain detailed information on
business
collateral, such as real estate and machinery and equipment,
the
bank sometimes can get it from your Federal income tax returns.
Reviewing
the depreciation which you have taken for tax purposes on
such
collateral can be helpful in arriving at the value of these
assets.
If
you are a good manager, you should have your books balanced
monthly. However, some businesses prepare balance
sheets less
regularly.
In filling out your "Balance Sheet as of ______ 19 ____,
Fiscal
Year Ends ________," remember that you must show the condition
of
your business within 60 days of the date on your loan application.
It
is best to get expert advice when working up such vital information.
Your
accountant or banker will be able to help you.
Cash
Budget
(For
three months, ending March 31, 19___)
----------------------------------------------------------------------------
January February March
Budget Actual Budget Actual
Budget Actual
---------------------------
______ ______ ______ ______ ______ ______
Expected
Cash Receipts:
----------------------------______
______ ______ ______ ______ ______
1. Cash sales
----------------------------______
______ ______ ______ ______ ______
2. Collections on accounts
receivable
----------------------------______
______ ______ ______ ______ ______
3. Other income
----------------------------______
______ ______ ______ ______ ______
4. Total cash receipts
----------------------------______
______ ______ ______ ______ ______
Expected
Cash Payments
----------------------------______
______ ______ ______ ______ ______
5. Raw materials
----------------------------______
______ ______ ______ ______ ______
6. Payroll
----------------------------______
______ ______ ______ ______ ______
7. Other factory expenses
(including maintenance)
----------------------------______
______ ______ ______ ______ ______
8. Advertising
----------------------------______
______ ______ ______ ______ ______
9. Selling expense
----------------------------______
______ ______ ______ ______ ______
10.
Administrative expense
(including salary of
owner-manager)
----------------------------______
______ ______ ______ ______ ______
11.
New plant and equipment
----------------------------______
______ ______ ______ ______ ______
12.
Other payments (taxes,
including estimated
income tax; repayment of
loans; interest; etc.)
----------------------------______
______ ______ ______ ______ ______
13.
Total cash payments
----------------------------______
______ ______ ______ ______ ______
14.
Expected Cash Balance at
beginning of the month
----------------------------______
______ ______ ______ ______ ______
15.
Cash increase or decrease
(item 4 minus item 13)
----------------------------______
______ ______ ______ ______ ______
16.
Expected cash balance at
end of month (item 14
plus item 15)
----------------------------______
______ ______ ______ ______ ______
17.
Desired working cash balance
----------------------------______
______ ______ ______ ______ ______
18.
Short-term loans needed
(item 17 minus item 16, if
item 17 is larger)
----------------------------______
______ ______ ______ ______ ______
19.
Cash available for dividends,
capital cash expenditures,
and/or short investments
(item 16 minus item
17, if item 16 is larger
than item 17)
-----------------------------------------------------------------------
Capital
Cash:
----------------------------______
______ ______ ______ ______ ______
20.
Cash available (item 19
after deducting dividends,
etc.)
----------------------------______
______ ______ ______ ______ ______
21.
Desired capital cash (item
11, new plant equipment)
----------------------------______
______ ______ ______ ______ ______
22.
Long-term loans needed
(item 21 less item 20, if
item 20 is larger than
item 20)
----------------------------______
______ ______ ______ ______ ______
-----------------------------------------------------------------------
Again,
if your records do not show the details necessary for working
up
profit and loss statements, your Federal income tax returns may be
useful
in getting together facts for the SBA loan application.
Insurance
SBA
also needs information about the kinds of insurance a company
carries.
The owner-manager gives these facts by listing various insurance
policies.
Personal
Finances
SBA
also must know something about the personal financial condition of
the
applicant. Among the types of information are: personal cash
position;
source of income including salary and personal investments;
stocks,
bonds, real estate, and other property owned in the
applicant's
own name; personal debts including installment credit
payments,
life insurance premiums, and so forth.
Evaluating
the Application
Once
you have supplied the necessary information, the next step in the
borrowing
process is the evaluation of your application. Whether the
processing
officer is in a bank or in SBA, the officer considers the
same
kinds of things when determining whether to grant or refuse the
loan.
The SBA loan processor looks for:
(1)
The borrower's debt paying record to suppliers, banks, home
mortgage
holders, and other creditors.
(2)
The ratio of the borrower's debt to net worth.
(3)
The past earnings of the company.
(4)
The value and condition of the collateral which the borrower
offers
for security.
The
SBA loan processor also looks for: (1) the borrower's management
ability,
(2) the borrower's character, and (3) the future prospects
of
the borrower's business.
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