Businesses typically use a line of credit to maintain or expand a business—not start a new one. A line of credit provides business owners much needed short-term working capital to meet payroll, pay vendors, or purchase raw materials. Failure to obtain credit is associated with having low credit scores, fewer unencumbered assets, and being located in areas experiencing economic downturn.
Bad credit is defined by FICO as a score of 300 to 629. One way entrepreneurs can ease the pain of poor credit is to establish a rapport with a banker long before they apply for a loan. This isn’t the teller whose kids’ names you know when you deposit your checks. This is a business banker who understands your industry—a trusted advisor on par with your accountant or lawyer. Ask a branch manager for a referral, then tell the business banker who you are, what you do, and ask how he or she can help grow your company.
What else can business owners do to improve their chances? They can maintain good financial controls and try not to completely kill profits to manage taxes. Banks can’t lend on cash flows that don’t get formally reported.
Here are four areas loan officers say they will examine before granting you a line of credit:
1. How will a credit line help your business?
Lenders look at how the funds will be used. The most common uses include funding inventory, accounts receivable, and capital equipment. They’ll also look at what the business does—who does it sell to and buy from—and ask general questions about the company’s business model.
2. What are your annual net revenues?
You must prove that the business has lasting earning power, which means you’re generating net income. Yearlong monthly cash flow statements will reflect this net income. Lenders like to see enough ongoing cash flow to cover all expenses, including the proposed loan payments. A seasonal lull can be reconciled, but a drastic drop in revenues year after year would cause concern.
3. How far out are your receivables?
Typically, a credit line is secured with accounts receivables. Lenders like detailed accounts receivable aging—categorized as current, more than 30 days, 60 days, and 90 days. Most financial institutions will not include accounts receivable that are more than 90 days past due when determining the line of credit.
4. What’s your debt–service coverage ratio?
Lenders typically look for 1.25:1 debt–service coverage ratio. This means for every one dollar of debt that you owe or you want to finance, they want you to have $1.25 of income. Financial net worth and liquidity are important when the lender is looking for a secondary source of repayment.