Applying for a small business loan can be tricky, but the key to a successful application—as with most things in life—is preparation. Understanding the application process and what lenders look for will maximize your chances of approval.
Here, we’ll help you determine your business needs and how to best prepare to take out a business loan.
Is Your Small Business Creditworthy?
Creditworthiness is a valuation that lenders use to decide how risky you are as a borrower.
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Lenders will look at your creditworthiness—both personal and business—to determine whether or not to extend your business credit, and on what terms. Similar to your personal credit report, your business credit reports document the credit history of your business (such as the timeliness of your payments and any missed payments) and your business credit score.
While lenders will look at both your personal and business credit history and credit score, it is important to keep these entities as separate as possible when running your business.
By using business credit for your business expenses, you will establish—and build—credit history for your entity, which will come in handy when you’re considering debt financing. You should be using business credit (such as a business credit card) and paying off your balance every billing cycle in full and on time. You should also be regularly checking your business credit report from at least one of the business credit reporting agencies—Experian, Equifax, and TransUnion. Just be sure to not fall into the trap of using your business credit for your personal expenses as this can lead to a lot of headaches—both legally and financially.
Why Personal Credit Matters
Lenders are evaluating the risk of extending credit to your business, and they need something to help gauge how likely you are to repay the “IOU.” How you handle payments on a personal credit card provides lenders with insight into whether you’ll be able to manage future payments on a $50,000 business loan.
The best way to manage your personal credit history and credit score is to make payments in full and on time. It is also important to check your credit report on an annual basis, as errors do occur, and can affect your ability to borrow. Once every twelve months, you can access your free credit report from each of the major credit reporting bureaus – Equifax, Experian and TransUnion—from Annual Credit Report.
Determining Your Small Business Loan Amount
Lenders will be evaluating your requested loan amount against a number of factors such as your intended use of the funds, the financial health of your business, and ability of your business to repay the loan. A good lender will not give you a term loan for a financing need better met by a business credit card or merchant cash advance. You also have a better chance of getting approved for a small business loan if you have a well-thought-out explanation for the amount of money you need, and why you need it.
Lenders will also measure your ability to repay by calculating your business’s debt service coverage ratio (DSCR). DSCR is a ratio that compares the amount of cash a business has available to the debt it has taken on. It is calculated by dividing your net operating income by your annual debt obligation.
DSCR = Net Operating Income / Annual Debt Obligation
Net operating income is your business’s annual revenue minus your cost of goods sold (COGS) and your operating expenses (not including taxes or interest payments). Annual debt obligation includes payments on all business obligations that you currently have as well as the loan that you’re applying for. Lenders will want a DSCR of at least 1.15, but more typically 1.25 and above (anything under 1 means negative cash flow).
Required documents vary based on the lender and the loan product. You’ll want to check the criteria prior to applying, but it’s likely you’ll need:
- Tax EIN (tax returns)
- Financial statements (balance sheet, income statement, cash flow statement)
- Bank statements
Once approved for the loan, you will want to analyze the loan offer to make sure it meets your business needs.
You should evaluate the Annual Percentage Rate (APR). This is a calculation of interest, taking into consideration all other fees associated with the small business loan. As such, it reflects the true cost of the loan. You will also want to make sure the repayment terms work for you and your business.
Once the terms meet your satisfaction, sign the required paperwork and you will be on your way to achieving the next chapter of your business aspirations.