Author: Ash Chandler

How Cash Flow Influences your Ability to Borrow

How Cash Flow Influences your Ability to Borrow

Business lenders put a high value on analyzing a borrower’s cash flow.  It’s seen as having significant predictive value in whether the borrower can pay back the loan since it will usually be the primary source of funds for repayment.  The financials that a lender requires varies but they will typically look at one or more of the following: bank statements, tax filings, and internal financials (such as a Profit and Loss statement and a Balance Sheet).

Earnings

A good place to begin is your EBITDA – earnings before interest, tax, deductions, and amortization.  This value should match across your records; in other words, the earnings you report on last year’s business tax filings should be the same that you’ve arrived at in your internal financials.  Often, lenders will have a form that you will sign in applying for a loan that allows the lender to verify your tax records with the IRS.  This means they will ensure that whatever tax records you supply match precisely with the ones that you filed.   Lenders have been doing this a long time- and they have processes in place to check for data consistency across a borrower’s file.

How Earnings Impacts Debt Service Coverage Ratio

Debt service coverage ratio (DSCR) measures the availability of a business’ cash flow to pay its debt obligations.  The formula is:

Earnings Before Interest and Tax (EBIT)   /   Total Debt Service Payments

A DSCR of 1 means that a business earns just enough to cover its debt obligations.  It means that Earnings and Debt obligation payments are exactly equal and would cancel each other out.

Put yourself in the position of a lender.  How comfortable would you feel if you let someone borrow money and learned that they earn just barely enough to pay back the debt?  You know that any change in the borrower’s circumstances could be enough to reduce his ability to afford the debt- a reduction in income, an unexpected expense, etc.  He is right at the razor’s edge and there is little margin for error.  For this reason, lenders – whether they be banks or alternative lenders – look for a DSCR comfortably above 1.  It varies but you may see a requirement of 1.15 for lenders with looser criteria or 1.25 for a lender with tighter criteria.

For example, the Small Business Administration (SBA) loan program, states the following in “Credit Standards for SBA Lending” for loans over $350,000:

Debt service is defined as the future required principal and interest payments on all business debt inclusive of new SBA loan proceeds. Business applicant debt service coverage ratio (OCF/DS) must be equal to or greater than 1.15 on a historical or projected basis;

The lender will consider not just existing debt obligations but the total debt obligations including the new loan.  In the case of a business loan, the lender may evaluate the DSCR of both the business and the owner.  A sufficient DSCR, as determined by analyzing a business’ cash flow, gives a lender confidence that its loan will be repaid.  This is why cash flow ranks so highly to lenders when they evaluate the loan application.

Improving your Cash Flow

Improving your cash flow processes leads to a better financial picture and it therefore improves your standing for getting a business loan.  Roughly speaking, there are two main processes affecting cash flow- accounts payable and accounts receivable.  This relates to money you owe other companies and money you are owed.

Prioritize Collections & Advance Payment

Business owners often begin with a trusting attitude when it comes to their customers paying them what they are owed.  The tasks of running a business easily fill the day, and the time and willingness to collect overdue payments sometimes isn’t there, especially since it often entails uncomfortable conversations.  However, it’s necessary for a small business owner to prioritize collection from customers who are late on payments.

One solution to delayed payment is to collect payment upfront.  When you start, more lenient payment terms may be used to ensure an initial customer base.  As you earn trust with your customers, it is acceptable to ensure smooth business operations by insisting on being paid ahead of service or product delivery.  If you have an ongoing service, you can bill at the beginning of the month or week.  If you have adequate security measures, you can also keep the customer’s credit card on file and, with the permission of the customer, charge it at regular intervals.

In some cases, it may be appropriate to charge for more than one pay period upfront.  For example, if you sign up for a WordPress.com blogging account, they cite a cost per month, but they inform the customer they will be charged on that per month basis for 12 months, up front.  This allows the business, WordPress in this case, to augment their cash flow position by receiving the payment in their bank account as early as possible.

In a way, receiving upfront customer payment is a bit like receiving a loan from the customer- a kind of financing that provides cash immediately and allows you to attend to your business expenses with those funds.

Negotiate Payment Terms with Vendors

Many vendors offer varying payment schedules but don’t publicize them.  For example, they may claim Net 30 days is standard but after a discussion with your vendor contact, they are willing to move your account to Net 60 days.  The delayed payment terms businesses offer each other is called trade credit.   Chances are, your business may have simply scratched the surface on what’s possible as far as fully taking advantage of trade credit with your vendors.

By pushing payments out further and receiving revenue sooner, your business before and after is technically the same.  Your product or service remains the same, your customer base stays constant and so do your stable of vendors.  But you are a very different company from a financial point of view – and this is what lenders are evaluating.

Cash Flow and Borrowing

Optimizing your cash flow is a good thing to do, period.  It also has the advantage of bettering your chance at receiving a loan, or increasing the size of the loan you qualify for.   If you’re interested in better understanding your company’s cash flow (as well as improving it), there may be a Small Business Development Center (SBDC) near you.  SBDC’s are a program of the SBA; they are hosted by colleges and state economic development agencies.  They provide classes and guidance on an array of subjects affecting small business owners, including how to track your cash flow & tips for how to keep your cash flow healthy.

The more familiar you are with your cash flow, the better you can explain the cost and revenue dynamics to your lender.  Given the importance of cash flow, the reality is that a well-liked business with a product in-demand that doesn’t have a tightly watched and controlled cash flow may not be eligible for a loan.  Meanwhile, a smaller business that has efficient methods of collecting payments from customers and has secured extended payment terms from the businesses it buys from, may well be eligible for financing.

Famed business consultant and author Peter Drucker once said, “Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.”   This saying applies to small business lending as well.

Business Credit Score Basics: a Primer

Business Credit Score Basics: a Primer

Did you know that, as a business owner, you don’t just have one credit score, but two?!

You have your personal credit score.  But your business also has a business credit score.  According to “Business Credit Decoded”, 90% of small businesses are unaware that their business has a unique business credit score independent from the owner’s personal credit score.

The Big Three consumer credit reporting agencies are: Equifax, Experian, and Transunion.  You’ve probably heard of some or all of them.  You’ve heard of the FICO score and you’ve seen the reporting agency names referenced on popular credit score sites like CreditKarma.  People are generally pretty familiar with the personal credit score.  It comes up in conversation.  When you apply for a mortgage, it’s one of the first items mentioned by the mortgage lender in terms of trying to ascertain which loans you qualify for and at what rates.  There are countless articles and books on how to improve your credit score.

But in contrast, business owners may go years before they become acquainted with the DUNS number, Paydex score, Intelliscore, or Dun and Bradstreet.  According to Entrepreneur.com,  less than 10% of small business owners were familiar with the concept of a business credit score (as distinct from consumer credit score).  However, this phenomenon is good news for those business owners who take the time to get up to speed on business credit and thoroughly understand how to put it to use on their company’s behalf.  The 90% of  business owners know nothing about business credit means more money available for the small percentage who do.

Companies ranging from Dell to Home Depot provide special programs and payment terms to companies depending on their business credit score (even though these programs of theirs are not “well-advertised”).  Companies from business lenders to leasing companies evaluate your worthiness based on your business credit score as well.  In other words, companies you’ve done business with have likely judged your eligibility for all kinds of programs and payment schedules without your knowing about it.

But how is a business credit score measured and how is it calculated?

Basics on the Business Credit Score

The consumer credit score goes from 300 to 850; a 300 credit score is lousy and most lenders will avoid the borrower like the plague.  Experian considers a consumer credit score of above 740 to be super-prime; these borrowers are eligible for the most loan programs at the best rates.  The definition for sub-prime borrowers varies and there is no fixed definition.  However, many define sub-prime as a consumer credit score of under 640.   “Sub-prime” was much mentioned in association with the 2008 global financial crisis due to the housing bust brought about, in large part, by sub-prime borrowers who defaulted on their loans.   Such sub-prime borrowers are generally now excluded from consideration for mortgage loans, and are often rejected for other kinds of loan products such as credit cards and auto loans.

The business credit score has a different scale than the consumer one.  It goes from 0 to 100 (instead of 300 to 850).  Of the three main business credit reporting agencies, two are familiar, as they are major players in consumer credit reporting: Experian and Equifax.  But instead of TransUnion rounding out the top three, the third major business credit reporting agency is Dun & Bradstreet – the most influential business credit scoring company.

How is my Business Credit Score determined?

The business credit score (from 0-100) is a percentile score.  It is relative to other businesses and reflects the percentage of businesses that you score higher or lower than.  That is, if your business score is 70, that means that you have a stronger credit than 69% of the businesses out there, but there are 30% of businesses that have stronger credit than you do.

The main business credit scores are:

  • Paydex : business credit score by Dun & Bradstreet
  • Intelliscore: business credit score by Experian
  • Business Credit Risk Score: business credit score by Equifax (note: Equifax offers range of business credit scores that each use different number ranges)

The business credit score is largely determined by a business’ history of paying back its suppliers and vendors.  A score of 80 or higher is considered “good” or healthy credit.  A strong business credit score can be secured by ensuring payments are made promptly to suppliers and vendors.  It’s important for a business owner to have those accounts report favorable payment history to the business credit reporting agencies.  If bills are paid on time, the business credit score will be positive. But if payments are made late, the business credit score will drop.  The score will adjust according to how early or late the bills are paid.  If bills are paid on time consistently, then that business will likely have a score that is 80 or greater.

How on-time bills are paid is the main driver of the business credit score like Paydex or Intelliscore.  It’s a solid indicator to lenders of how likely that business is to make good on its financial commitments at an agreed-upon date in the future. Lenders evaluate this score carefully when deciding whether or not to give a business a loan.  Another important aspect of the Paydex score is that it is a “weighted average” score. This score gives more weight to the trade accounts that report greater amounts of credit extended and less weight to accounts that report lower dollar amounts of credit.
Have a look at the following graphic to better understand how individual payment events with vendors/suppliers get scored.  The cumulative scoring averages of these payment events contributes to the overall business credit score.

Source: “Business Credit Decoded”

As you can see, on-time payment yields a score of 80.  The earliest payment yields a score of 100.  The more delayed the payment on bills, the lower the score received.   Likely, not every one of your vendors and suppliers reports transactions to the business credit reporting agencies, but some of these transactions are captured, and overall, they are carefully monitored to calibrate the overall business credit score of your business.

Just as the consumer credit score has different components, such as history of repayment, credit utilization, length of time credit accounts have been active, etc., the business score has its own components that make it up.

For the business credit score, current payment status, trade balances, and percent of accounts delinquent account for 50-60% of the score makeup.   The historical behavior/payment history contributes 5-10% of the total score. The business’ credit utilization is responsible for 10-15% of the total score.  This has to do with the amount of credit that has been used by the business in relation to the balances they have on those accounts. The company profile, industry risk, age of business,  and size of business assessed by number of employees accounts for 5-10% of the total score.  Approximately 10-15% of the score is influenced by the derogatory items, collections, liens, judgments, and bankruptcies that business has.

In the following image, the components of the business credit score are summarized:

Source: “Business Credit Decoded”

Experian’s Intelliscore (an alternative to Dun & Bradstreet’s Paydex score) reveals other factors taken into consideration for their business score.  When Experian is assigning a business a credit score they take different factors into account. They refer to these factors as predictive data; they leverage predictive data to gauge a business’s risk as a borrower. The score is made of different components such as:

  • how recent are the delinquencies
  • how many accounts are current versus delinquent
  • average balances on accounts
  • the percent of balances seriously delinquent
  • the credit utilization ratio
  • balances on leases.

Experian describes firmographics as the background information of a business such as the industry/sector it operates in and the size of the business (measured by how many employees it has).  Firmographics also take into account the length of time the business has been reporting to Experian. They have found that a business with a longer Experian credit file, in terms of years in existence, is less likely to default.   

Experian also provides reports that reflect information about the business and the business owner’s personal credit history called “blended” reports.  The”blended” score of the business – which combines the business credit score with that business owner’s personal credit score – with the idea being that the two are both related to the likelihood of that particular business paying what they owe.

Studies show that consumer reports don’t offer the most comprehensive assessment of risk on their own. With blended reports Experian takes into account both factors from the business and from the consumer credit of the owner or personal guarantor.  The blended score factors in things like number of personal credit cards with 90%+ utilization.

Going Forward

Having a basic awareness of the business credit score puts you ahead of a surprising number of businesses who don’t realize that their payment histories are being carefully tracked and that this business score impacts what loans their business is eligible for.  This primer gives you the fundamentals of what the business credit score is, what contributes to it, and how it’s calculated.  While there is more to it, and certainly a fair number of techniques that can improve your score, it’s clear that maintaining a reliable payment schedule to vendors and suppliers is important to sustaining a strong business credit score.

Why Character is King when it comes to Getting a Business Loan

Why Character is King when it comes to Getting a Business Loan

Lenders talk about the 5 C’s regarding business borrowers:Cash Flow, Collateral, Capacity, Conditions, and Character.

Cash Flow has to do with the amount of cash the business generates.  It looks at the business’ revenue and its expenses.  Cash flow analysis identifies the earnings a company produces; the lender knows those earnings will be used to pay down the loan interest payments and principal so it is look for sufficient earnings.  Collateral has to do with the business’ assets such as equipment and inventory.  If need be, the business can sell its collateral to make good on its commitment to pay down the loan.  Capacity has to do with personal assets the business owner has.  If cash flow and collateral is insufficient to pay back the loan, the owner can always rely on these personal assets.  That’s why if the owner has real estate or a large personal bank account, this will increase the likelihood a small business will be approved for a loan.

Conditions refer to the general economy; are we headed for a recession, or are we in the early stages of a growing bull market?  Lenders will lend more in the latter than the former.

But beyond these four elements is the fifth- Character.  Character can be defined 100 different ways by 100 different lenders.  But ultimately it has to do with the honesty and integrity of the borrower.  Character impacts all the other C’s because if a borrower is dishonest, the lender may not believe the provided documents to attest to Cash Flow and Collateral, for example.  A dishonest borrower may forge or manipulate these documents.  So how will a lender ascertain your character?

For some lenders, they keep it simple.  They evaluate your personal credit score as a proxy of character- the sum of your past willingness to keep your commitments to lenders.  Others will also order a background check of you and other owners to determine if there is any criminal history or indicators of lack of commitment, such as defaulting on student loans.

According to “Money, Money Everywhere”:

Character. It’s a crucial step in the loan application process. You must convince your banker you have what it takes to succeed…..For them, for bankers today, determining character is the most important task. If they purchase an item, or take one in on loan or pawn, and that item is stolen or fake, they lose their entire investment. This is no different than any other borrower from the bank. If the intention of the borrower is not to pay back the loan, in actuality there is little the bank can do about it…..

Your reputation was defined in the past by your associations in the neighborhood, but today that reputation is more defined by how you show up on Internet search engines.

Did you do your assigned homework and Google your name? Bankers now understand more than ever that Google helps define your character. When the banker types in your name and an unflattering article pops up, that will be extremely negative to your case…..Other character tests are old school. In the past, it was important what organizations you belonged to, what country club you belonged to, and the lineage of your mother and father. Google has replaced that caste system.

If you there are negative accounts written about you on Google, there are ways to address it.  You can contact the website and request a take-down of the offensive material.  Another option is to work with a company that specializes in improving online reputation such as Reputation Defender.  Companies like Reputation Defender create original content and use search engine optimization to rank positive articles about you while pushing down in the search engine negative accounts.  This means that when people search your name, they will see the good representations and may not see the negative accounts unless they click to later pages on Google.

Knowing that Character is central to loan approval means that you can take proactive steps in preparing yourself prior to the loan application to give yourself the best shot of approval.

Restaurant Small Business Loans – Being Prepared for the Loan Interview

Restaurant Small Business Loans – Being Prepared for the Loan Interview

The kinds of questions that a lender will ask depends heavily on the nature of the business of the borrower.  Restaurants, just like any other business, have their own peculiarities.  A lender’s job is to get paid back with the least hassles and when deciding whether a restaurant should get a loan, his task is no different.  What is different is what data he looks for when discussing the loan with the borrower.

An excerpt from the book “Money Money Everywhere” explains some of the questions a lender may ask:

For a restaurant, one matrix could be the average size of the check for the lunch crowd, and is it growing or shrinking? For dinner, is your customer’s alcohol consumption up, or down? How many special events do you have planned for next month? What percentage of your sales comes from catering? What are your gross margins on the new buffet you introduced?

As you can see, the questions are industry-specific.  Lenders are impressed when borrowers have these figures on the top of their head; they can recite them instantly.  They know the average bill of their customer; they know if it’s trending up or down.  And even better- they know why.  If you’re in the restaurant business, you know there are a multitude of factors why this might be – new competition, trends in terms of demographics in the neighborhood, menu changes, etc.

The book also points out the difference between perception and reality as far as restaurant loans:

One of the great disconnects in the small business lending industry is the fact that we all see the failure rates for restaurants are staggering yet restaurants continue to be the number one receiver of small business loans.

Lending still has an emotional and qualitative dimension.  Sure with online lenders, much of the restaurant loan application has become numerical or mathematical.  But even with such lenders, they will often follow-up an online application with a phone call to inquire further, often wanting to know information about the business specific to it and specific to the industry it operates in.  In this qualitative dimension, some lenders may operate on the bias or mistaken assumption that restaurants fail at a disproportionate rate so it’s important to be able to explain the financial strength of your business with real data.  Generally, citing data from a one-year old balance statement won’t cut it.  Most lenders want to see that the borrower is on top of their current financials.  When going through the loan application phase, it’s not a bad idea to keep a cheat sheet of your key financial indicators to refer to when talking with lenders.

To summarize from “Money, Money Everywhere”:

Bankers aren’t stupid and they know the risks that come with restaurants, but they still do it. If you want to be one of those restaurant small-business borrowers, you need to first convince yourself that the business is viable and then convince the Old Man sitting behind the desk.

Being prepared to discuss your restaurant’s financials will put you in the best position to be approved for the restaurant small business loan, whether you apply to an online lender or a traditional one.

BorrowStar

BorrowStar provides insight and information to small businesses looking to secure a loan for working capital, inventory, expansion, franchising or whatever the need may be.  We aim to provide objective, crisp walk-throughs and guides so you can make a better & more informed decision.

The good news is that there are today, thanks to the Internet, a large variety of choices that small businesses have when it comes to getting a business loan.  This wasn’t always true when mainstream banks dominated the landscape; the rejection rate was higher as banks demanded to see a certain amount of assets or a lengthy tenure before they would consider loans.  Today, a multitude of online lenders, including non-bank lenders, vie for your business.  Often, they offer loans to a high percentage of applicants, and without cumbersome paperwork.  However, there are always disreputable organizations that take advantage of the anonymity of the Internet and are unreliable.  BorrowStar aims to aid you in your evaluation of lending products and make the best choice for your business to grow and thrive!