The small business lending model is quite simple. The interest rates earned from the loan payments should be higher than the probability of the bank not getting paid back. For instance, in case the traditional lender considers that there is a 20% chance they will not get their cash back, they have to lend you the cash at 25% Annual Percentage Rate (APR) with the intention to protect their risk.
The issue is that 25% interest is taken into consideration usury in many states and is therefore illegal. To be able to lend to a small business at a more affordable rate of 6-9%, the bank must be at the least 95% sure that the loan will not default. Now do you see why it is so hard for small businesses to get funding?
At the same time as it may feel impossible, the fact is that some small businesses do acquire traditional funding. So what is their secret? How does the bank get 95% certainly? The banks turn up at this number by way of determining different factors that contribute to default risk. Their intention is to ensure all signs identify the small business succeeding and generating a reliable source of revenue.
10 Point Lender’s Checklist
There are 10 major areas of focus that banks measure to determine the default risk on a small business loan:
- The Industry The Business Works In
Even though only 50% of small businesses make it past their first few years of operation, this failure rate varies greatly by industry. For instance, hospitals and medical facilities have a much better survival rate as compared to retail shops and restaurants.
- Time In Business
As the businesses grown-up, they get better and better in their operations. They add to their market share, build a loyal customer base and gain a positive reputation in the market. The survival rates of businesses increase quite rapidly; a small business with a couple of years of knowledge and experience of the market shows a lower default risk.
- Financial Ratios And Profitability
Does the small business have sufficient amount of profits to be able to not only pay back the borrowed amount; however the interest as well? Lenders additionally observe financial competence as well as cash flow. The financial competence represents the business’ ability to pay for their current liabilities. The word liquidity also denotes to collateral that the lender (bank) could liquidate without difficulty in case the business is unable to pay back the borrowed amount. If a small business doesn’t have anything to place as collateral, then the lender considers the value of all the assets that business possess.
- Business Model
Is your current business model especially designed to survive in the economic, social or political and environmental fluctuations? Do you in place a sound method to reduce the possible risk of changes in the current market conditions?
- Credit History
Does your small business have effective credit history with your vendors? As a business owner, do you have good personal credit? Due to the fact that many small businesses do not have good credit history, the business owner’s credit score plays an important role.
- Personal Guarantee
Do the small business loan guarantors and small business owners have confidence in the business strongly enough to be personally accountable for paying back the borrowed amount in case the business fails?
- Liens And Tax Liability
It is essential for the bank to make certain that there aren’t any outstanding liens against your business resources/assets and/or current potential lawsuits that can put your small business at big financial hassle.
- Owner’s Equity
The bank wants to see that the small business owner has his own money in the business and is willing to risk that money, not just the cash from small business loan. The lender also considers the total current debt when borrowed from different banks. The business cannot already owe large amounts of cash to different banks or even to third parties because it makes it much difficult to collect.
- Loan Objective
In other words, banks want to make certain that your loan request makes sense. For instance, if you are going to borrow to buy expensive equipment business is going to borrow with a view to buy expensive equipment that will last 5-7 years, then a 5-year loan makes sense. However, if your business needs short-term cash, then a business line of credit can help you.
- Receivable Concentration
This is basically determining the concentration versus the diversification of a business’ revenue streams. There are advantages and disadvantages to both of these.
Our infographic below illustrates the 10 point lender’s checklist that you need to know before applying for a small business loan.