Author: SBR
All growing businesses reach a critical juncture when they must decide if business financing is the right solution for getting to the next level. The big mistake many business owners make is to wait until they need financing to learn about their options and what it takes to qualify for credit. If they’re not prepared to borrow, they may end up with poor financing terms, if they can qualify at all.
Business owners with ambitions of growing their businesses must assume that, at some point, they will need an infusion of capital that will more than likely come from financing. They may not need it today or in the foreseeable future, but if they’re doing things right, the time will come, and they need to prepare sooner rather than later.
That requires having a clear understanding of how lenders evaluate your credit and working to prepare your business accordingly. While the methods for assessing a business’s credit standing can vary among lenders, most utilize a similar framework built around the five elements of good credit—credit history, capacity, capital, collateral, and conditions. A business might scope out well with four of the elements but get rejected if one doesn’t meet the lender’s standards. So, it’s critical to clearly understand the intricacies of each and how they are evaluated by lenders.
Credit History
While lenders will evaluate your personal credit history, they also want to know how well your business manages credit. At a minimum, they want to see an established track record of borrowing and paying back loans. If you haven’t already, you need to separate your personal and business finances, focusing on building a credit history for your business. That could start with obtaining a business credit card and building financing relationships with vendors and suppliers by opening trade credit accounts.
From there, you need to closely track your business credit profile with the three business credit bureaus—Equifax, Experian, and Dunn & Bradstreet—who compile a credit profile for your business and will generate a credit report upon request. The business credit report includes background information on your business, financial information, banking and collection history, and history of liens or judgments. They also produce a risk score, which, like a credit score, measures creditworthiness. Unlike credit scoring of your personal credit, which is based on a standard set of factors, each credit bureau uses varying factors to calculate your business’s risk score.
In building your business credit, you can’t let your personal credit slide. When applying for financing, lenders consider both your business and personal credit in evaluating overall credit risk. The key is to keep your credit balances low on your personal and business lines and always make on-time payments.
Capacity
The most important consideration for lenders is whether a business has the ability to repay a loan and meet payment obligations. Lenders look to your business’s profitability and cash flow as evidence that you are financially able to take on credit. They will also consider the business’s cash flow projections to determine if it has the capacity to meet long-term obligations.
Capital
Lenders scrutinize the business’s bottom line for clear indications that it has sufficient capital—more specifically, that its assets sufficiently exceed its liabilities. Lenders want to know that if things start to go south for the business, it has sufficient assets to convert into cash if necessary. Lenders consider it a big plus if owners have their own capital tied up in the business, showing skin in the game and a commitment to the business’s success.
Conditions
When evaluating your business’s capacity to repay a loan, lenders consider several external and internal factors that could impact your business’s finances. For example, they might perform a “stress test” to see how your business might perform in a recession. They also look internally to see if your management team is capable of growing a business in any economic environment, reviewing their experience and educational background to assess their abilities.
Collateral
Depending on the type and amount of financing, lenders may require collateral to back a loan. Collateral reduces lender risk and improves your chances of qualifying for a loan. In some cases, if you’re using capital to purchase equipment, inventory, or property, they can be used as collateral. If you don’t have sufficient business assets to offer as collateral, lenders will look to your personal assets.
Business owners with expectations of getting to the next level must anticipate the need for capital well in advance or risk losing out on opportunities. If it’s not coming from investors, it will most likely come from financing. Using these five elements of good credit as a framework, businesses can map out a deliberate plan to successfully prepare to borrow.