Capitalization -- You Can Bank On It

By Vicki Parker
Published: September / October 2008

For the entrepreneur or small business owner, the lowest cost of capital is usually a traditional commercial loan from a bank. While the bank is keenly interested in the business and its success, it typically will charge a lower rate of interest and not require an equity stake for a business to borrow. The following is an overview of the process.

Before you approach your banker for a loan, you should understand the dynamics of your business, its cycle and the factors in its industry that impact it. Bankers are in the banking business, not the business of running your company and are most interested in how they will be repaid.

Bankers like information! The better prepared borrowers seem to fare well in their quest to obtain a loan from a bank. To that end, your first step should be to prepare a comprehensive package of information for your banker. If you have an established business, gather at a minimum the last three years of financial statements, including business tax returns; interim statements; 3 years of personal tax returns; pro-formas; and any other company, product or industry information that will help the bank to understand your business and where you plan to take it. If you are a new business or are significantly changing the scope of the business, the bank will typically require a business plan as well. The owners’ background, experience and résumés are useful information for a banker as well. It may be advantageous to engage your CPA or other finance professional to assist you in preparing projections and historical information.

The 5 C’s of Credit

A bank will use the information that you provide to perform its underwriting for the loan request. A large portion of this process will follow the 5 C’s of Credit. The first C is Credit. A bank wants to ensure that the business and its principals have maintained a strong personal credit history. Be prepared to explain any blemish in your past credit history - collection items, judgments, bankruptcy, etc. A business owner with a strong history of paying personal obligations on time and satisfactorily will generally see that his business obligations are met on time as well.

The second C is Cash flow. Banks want to ensure that a business has the ability to repay its obligations. Presenting historical as well as projected cash flows will be an essential step in securing a bank loan.

Collateral is the third C. Most banks shy away from unsecured loans. Real estate, inventory, accounts receivable and equipment are generally used to secure loans, depending on the loan purpose. As well, some banks may require that the business owner pledge equity in his residence.

The fourth C is Conditions/Climate. What is happening in your industry and greater economy? A bank will seek to understand the dynamics of your business within the framework of its industry and the economy in general to make assumptions on the future performance of the business and its ability to repay borrowed funds.

Capital is fifth and final C and perhaps the most difficult of the five for the entrepreneur to provide. The bank usually wants the owner(s) of the business to have monies at stake. How have you capitalized the business? What is its net worth and how leveraged is it?

Typical Loan Structures

Banks will generally structure loans similarly. Following are some typical structures for various types of loan requests. Real estate for businesses - banks will usually advance 80% of the cost or value of the real estate being purchased, constructed, or pledged as collateral. Increased occupancy costs or cost savings by owning vs. leasing will be taken into account in the underwriting process, so it is important for the borrower to understand these in their pro-forma. Amortization periods range from 15 to 30 years, depending on the loan type and the availability of various fixed and floating rate options.

Lines of credit for working capital are typically secured by the accounts receivable and inventory of the business. A bank will usually apply advance rates which vary from 75%-80% of accounts and 50-60% of inventory, depending on type and location. Asset based lenders will usually provide higher advance rates, but will require a more stringent monitoring process to insure their collateral and management’s financial reporting procedures and controls are satisfactory.

Term loans are generally used for the purchase of fixed assets and their amortization terms usually match the useful life of the underlying asset. Banks apply various advance rates by collateral types and the obsolescence factor. Don’t expect to get the same terms for technology equipment/software that you may for a more generic piece of equipment.

Most banks will require the majority owners to personally guarantee their business loans. Guarantees are used to ensure that the owners are committed to keep the company in good financial condition.

A well-thought-out business and financial plan combined with the right information will make applying for and receiving a commercial loan from a bank a much easier process. Doing your homework upfront will provide you a positive experience and allow you to grow your business.

About the Author
Vicki Parker is the Senior Commercial Banker at American Momentum Bank in Tampa, Florida. She has more than 22 years experience in credit and commercial lending.