Borrowing money is one of the most common sources of funding for a small business, but obtaining a loan isn't always easy.  Before you approach your bank for a loan, it is a good idea to understand as much as you can about the factors the bank will evaluate when they consider making you a loan. This discussion outlines some of the key factors a bank uses to analyze a potential borrower.   

KEY POINTS TO CONSIDER
Let's begin by exploring some of the key points your bank will review:

1. Ability to Repay/Capacity
The ability to repay must be justified in your loan package. Banks want to see two sources of repayment -- cashflow from the business, plus a secondary source such as collateral. In order to analyze the cash flow of the business, the lender will review the business's past financial statements. Generally, banks feel most comfortable dealing with a business that has been in existence for a number of years because they have a financial track record. If the business has consistently made a profit and that profit can cover the payment of additional debt, then it is likely that the loan will be approved. If however, the business has been operating marginally and now has a new opportunity to grow or if that business is a start-up, then it is necessary to prepare a thorough loan package with detailed explanation addressing how the business will be able to repay the loan.

2. Credit History
One of the first things a bank will determine when a person/business requests a loan is whether their personal and business credit is good.  Most banks have access to this information. Therefore before you go to the bank, or even start the process of preparing a loan request, you want to make sure your credit is good.

If you have been late by a month on an occasional payment, this probably will not adversely affect your credit. However, if you are continuously late in paying your credit, have a credit that was never paid and charged off, have a judgment against you, or have declared bankruptcy in the last 7 years, it is likely that you will have difficulty in obtaining a loan.

In some cases, a person has had a period of bad credit based on a divorce, medical crisis, or some other significant event. If you can show that your credit was good before and after this event and that you have tried to pay back those debts incurred in the period of bad credit, you should be able to obtain a loan. It is best if you write an explanation of your credit problems and how you have rectified them and attach this to your credit report in your loan package.

3. Equity
Financial institutions want to see a certain amount of equity in a business. Equity can be built up in a business through retained earnings or the injection of cash from either the owner or investors. 

Don't be misled into thinking that start-up businesses can obtain 100% financing.    A business owner usually must put some of her/his own money into the business. The amount an individual must put into the business in order to obtain a loan is dependent on the type of loan, purpose and terms. For example, many banks want the owner to put in at least 20 - 40% of the total request.

Example: A new business needs a $100,000 to start. The business owner must put $20,000 of her own money into the new business as equity. Her loan will be $80,000. The debt to equity ratio is 4:1. Note also that this is only one of many factors used to evaluate the business -- just having the right debt/equity ratio does not guarantee you'll get the loan.

4. Collateral
Financial institutions are looking for a second source of repayment, which often is collateral. Collateral are those personal and business assets that can be sold to pay back the loan. Most loan programmes require at least some collateral to secure a loan. If a potential borrower has no collateral to secure a loan, he/ she will need a co-signer that has collateral to pledge. Otherwise it may be difficult to obtain a loan.

The value of collateral is not based on the market value. It is discounted to take into account the value that would be lost if the assets had to be liquidated.

5. Experience
A bank is likely to more crebility to a loan applicant if the borrower has experience in the purpse of the loan rather than no experience at all.  It may be advisable to indicate to the bank that the borrower intends to hire people who know the business or take on a partner that has the appropriate experience. Regardless, applicants should be advised to take some time to work in the business first, and some training classes in the industry.

The key questions the bank will be seeking to answer are as follows:

1. Can the business repay the loan? (is cash flow greater than debt service?)
2. Can you repay the loan if the business fails? (is collateral sufficient to repay the loan?)
3. Does the business collect its payments for services rendered?
4. Does the business control its stock?
5. Does the business pay its accounts to suppliers?
6. Are the business owners and managers  committed to the business?
7. Does the business have a profitable operating history?
8. Does the business match its sources and uses of funds?
9. Are sales growing?
10. Does the business control expenses?
11. Are profits increasing as a percentage of sales?
12. Is there any discretionary cash flow?
13. What is the future of the industry?
14. Who is your competition and what are their strengths and weaknesses?.