As you can expect, instead of conducting their own audit on your accounts, lenders focus their attention span on just a few critical items from a company’s financial statements when assessing a business loan application. Whether your request for funds get an approval or immediately rejection is more often than not, dependent on one (if not all) of these items.
The truth is, whether you are a young start up that is one year old or an established 5 year operation, most of the items that lenders look forward to scrutinizing are essentially the same. Other than that, how healthy a business appear after a final rating is given can also play a part in what kind of interest rates you can expect to be offered.
Here are 7 items that banks and financial institutions will meticulously analyze to reach a conclusion of whether or not to grant you a loan.
1) Sales revenue
The first item to refer is probably the most important one. It is the sales figure. In different parts of the world, different terms such as revenue, income, turnover, can be used interchangeably. But they all mean the same thing. It is the total amount of sales that a business can generate within a year. A strong showing shows how well the target market is being monetized. On top of that a high revenue also shows how well a company will be able to service it’s debt repayments. The better the ability to service a debt the higher an approval quantum you can expect. This is the same case when we are talking about secured or unsecured borrowings.
2) Net profit
The second item to scrutinize is your net profit. For start-ups trying to get start-up funding, they will probably be required to submit a realistic projected net profit. Certain types of businesses have higher or lower profit margins. But those that belong to the low side tend to have a higher revenue. So it usually evens out.
Questions can arise when you fail to hit or maintain expected sales targets. If for example, your company has been consistently Making $500,000 in profits for the last 3 years, but somehow only managed $250,000 in the current financial year, credit analysts and approvers may start to question if the organization is going on a downward spiral which they are unable to recover from. The concern of lenders is always about risks. If there is sufficient evidence that the management of a company is running the organization down the gutters, lenders usually prefer to lose a client rather than take on a risky one.
In a situation where you company is operating at a loss, all is not lost. Because even in a loss-making company, it can have a positive net worth. You calculate that by summing up the company paid up capital with the incurred losses. If the end result still runs in the red, usually a lender will run like the wind or request that you increase your paid up capital to give them more assurance.
There are other tricks of the trade when you run into losses. In many cases, depreciation and amortization can be legitimately added onto net losses/profits as they are non-cash expenses. Meaning they are accounting expenses on paper but do not really cause you to lose money. This can help show a positive figure or a higher net profit.
When after all these methods mentioned above does not take your company into positive net worth territory, you do have one last throw of the dice. That is to include the Directors’ income statements into the calculations. This is actually a valid point. Many companies run into losses directly because the key promoters are drawing an obscene amount of money as salaries and bonuses. And since directors are most likely to be requested as personal guarantors for company loans, there is nothing wrong to insist that personal income statements are included in net worth calculations. Take note that we are not talking about public companies here.
Finally, the sugar daddy way works for a lot of people. Even if you have a loss making business, the odds are that a bank will still give you a loan if a third party billionaire guarantor comes into the picture.
3) Paid up capital
Paid up capital was mentioned briefly in the point above. Here is a more detailed look into it. A paid-up capital is often used to judge how serious the owners of a business is at committing to it. Nobody likes to deal with a two dollar company. A two dollar structure basically means that should the company run into debts, the most they are liable for is $2. This is why certain businessmen avoid dealing with such organizational structures like the plague. It goes without saying that credit approvers will be more impressed when there is a high capital in the first place.
To be in a position of positive net worth as mentioned previously, a simple equation can generally be used. Note that this equation is not universal and different lenders and credit professionals may have their own formulas to work out a number for net worth. Other items that are commonly included in equations include related party loans, director borrowings, shareholder loans, depreciation, amortization, etc.
Paid-up Capital + Retained Earnings (OR – Accumulated Losses) + Net
Profit (OR – Net Loss) = Net Worth
4) Trade Debtors
An item that business owners like to brag about is the amount of debts that are yet to be collected. As an ego boost, when this number is high, it shows that there a lot of people who owes him money. But to a credit analyst, a high figure for trade debtors in the accounts is something to be frowned at. Because on a cash flow point of view, it means that the business have problems collecting receipts from their customers. In essence, this means that the company is financing it’s debtors with interest-free money. These debts can also eventually become bad debts and be written off.
If the numbers for debtors are particularly high due to extended payment terms, make it a point to explain that to your loan officer. Do not wait until they ask you about it. Back up your claims with copies of the original contract and invoices clearly showing these terms. When these authentic documents are provided, nobody can question the authenticity of your claims.
But before you go on a rampage amending your payment terms with suppliers and vendors, do let it sink in that lenders are no fools. They deal with businesses in various industries each and every day. This means that they have a good idea what are the average terms used in different industries. If something looks out of place, evaluators are well trained to spot them like a sore thumb.
Another bad aspect that high debtors imply is that your business serves a huge number of customers who are bad paymasters. Since you depend on your collections to in turn repay the loan you are requesting for, considerable debtors do not help your application in any way.
5) Trade Creditors
Now that we have cracked open the often misunderstood number in debtors, it would now be clear that having a high figure for creditors is actually good. This might be a figure that can make a business owner sweat. But to credit evaluators, the higher this number gets, the more the business is getting free financing from vendors and suppliers. Yes, they are theoretically financing the company for free.
The ability to delay payments also indicates the company’s strong reputation in the industry. If you owe somebody money and that somebody allows you to delay payment until you are finally willing to pay, it says a lot about where the influence of the relationship is.
6) Inventory
Depending on the nature of business, inventory can be classified into 3 categories. They are raw materials, work-in-progress and finished goods.
While it might look ideal for a business to stock up on inventory to get ready for a sales rush or just to enjoy a bulk discount, a high inventory is something that credit analysts frown at. This is because money is essentially “locked up” here. Admiring your own warehouse that is packed to the ceilings with stocks and merchandise has a price to pay.
Among the 3 categories of inventory, raw materials has the most value in the eyes of a lender. This is because in the event of liquidation, they are the most easily marketable form of inventory in any industry. Raw materials can be sold to a host of varying buyers in different markets while finished goods like shoes can only be sold to wholesalers or retailers of shoes.
7) Related Parties Transactions
Related party transactions are one of those very closely watched items in business assessment.
This is because a loss making company can turn out to be profitable just from a cash injection from a sister company. In such an example, we might think that it is a lame attempt to financially beef up an organization when it isn’t doing that well. But from the viewpoint of an analyst, such an occurrence is actually good. Conversely, the opposite of giving out loans to related parties will be met with raised eyebrows.
The reasoning is very simple. Related companies are not expected to take each other to court to recover their money. The implication of these transactions is an impact on net worth. Loans going out has to be subtracted from net worth and loans coming in can be added. No lender will give out loans to borrowers with negative net worth.