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.
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.