I spend a lot of time here at the SBDC working with clients on financial issues for their businesses. A lot of the time, it involves applying for a business loan. Folks often don’t have a good understanding of what a bank will be looking for when making a lending decision.
The basic idea is not too different from getting a home mortgage. But the amounts are usually bigger and the process is longer. So, you need to plan ahead.
With a home mortgage, the bank wants to know if you have enough income to make the payments, is there adequate collateral, and what your credit score is. They want you to make the payments, because they do not want to have to foreclose on the loan and repossess you house. But, if they do have to foreclose, they want to be able to sell the house for at least what you owe on the loan, so they come out whole.
Cash flow, cash flow, cash flow – the three things that matter the most.
With a business loan, it’s a similar process to that of a home mortgage. But your personal income is replaced by the cash flow of the business. There is an unusual sounding term for cash flow that is VERY important to lenders:
- EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization
EBITDA is the cash flow that is generated by the business that is available to make loan payments.
Banks look at EBITDA and compare it to the loan payment. They want to know that the business is generating more cash flow (EBITDA) than the amount of the loan payments. Typical minimum hurdles:
- With real estate: EBITDA must equal 1.25 times debt service (loan payments)
- Without real estate: EBITDA must equal 1.5 times debt service (loan payments)
- Matt Pearce: I prefer that EBITDA be at least 2 times debt service (loan payments)
You may hear these multiples referred to as “debt service coverage.”
Example: If a business borrows $500,000 for 20 years at 6%, the loan payment is about $3,600/month, or $43,000/year. So, the minimum EBITDA that the bank would look for in this example would be:
- With real estate: 25 x $43,000 = $54,000/year
- Without real estate: 5 x $43,000 = $65,000/year
- Matt Pearce: 2 x $43,000 = $86,000/year
If you cannot figure out how to make the EBITDA for your business greater than the bank minimums, then you are simply working to make the loan payments. And, you will have very little cushion for when (not if) you have a slow sales month, or two, or three…
A Few Other Things to Keep in Mind:
Collateral:
In addition to cash flow, what is backing up the loan?
- Real estate – this is a bank’s preferred form of collateral.
- Equipment/fixed assets – not bad, but not as good as real estate.
- Inventory – not good – very low loan value – maybe 50% of your cost, if you are lucky.
- Receivables – can be done, but very expensive.
Owner’s equity:
How much cash are you putting into the deal? At least 10%. 20% or 30% is better. This will reduce your monthly payment and give you better cushion for slow times. Less risk. On that $500,000 loan, this means minimum down payment of $50,000, more likely $100,000.
I sometimes get asked if you can substitute equity in your personal house for a cash down payment. The answer is an unequivocal “No.” A cash down payment means real cash.
Business Plan:
Put together a good game plan that helps the loan officer understand why it makes good business sense to make this loan to you and your business. He won’t make the loan decision, but he can be your cheerleader inside the bank with the folks who will.
Time Frame:
This is not a quick decision like on a credit card or car loan. Figure 30 to 60 days for the bank to review your loan package, ask questions, and do its internal review. If the loan is an SBA loan, maybe add 30 to 45 days on top of that for the SBA to do its thing.
If you have any questions or would like to discuss your particular situation, please feel free to contact your local UGA SBDC office.
