Steps to securing business financing
Securing business financing can seem like a demanding process as there are several aspects the borrower needs to consider prior to applying including how much they need to borrow, how do they know if they qualify, what documents they need to provide and what types of financing are available to them.
If you are considering securing business financing, below are several important steps to guide you through the process of securing a note that best addresses your business’ needs.
Know your credit score: Lenders use an applicant’s credit score to determine how dependable you are when it comes to paying back debt. If you are unsure of your score (or you would like to check it), you can do so at no charge at various outlets including Nerdwallet or Credit Karma. It is also important to note any potential errors or issues that might hurt your eligibility (such as delinquent payments or major purchases made using a credit card). It should be noted that a higher personal credit score can oftentimes translate into more favorable interest rates, so it is important to take steps to improve your personal credit score prior to applying.
Address debt-to-income ratio: Before applying for financing, calculate your business’ debt-to-income ratio (DTI), which can be done through dividing the total amount of monthly debt payments by your business’ total monthly income. Lenders often use DTI to address a borrower’s ability to manage debt and payback borrowed funds. Generally, lenders will want to see a DTI of less than one, as the general rule of thumb is that the lower the ratio, the stronger the case for approval. Lending sources will be more likely to approve the application if a borrower can show that they can pay them back.
Identify the amount: Lenders will need to know how much you need to borrow and what you plan to use the funds for. Are you looking to cover payroll costs, purchase new equipment, buy a new operating facility, expand product lines, or simply want to have some excess cash on hand? Regardless of the reason for taking out the funds, the main thing is to identify how much you need. That amount will help determine which type of financing you should take out. But before identifying the amount, it will be helpful to calculate how much you can afford to borrow.
Determine how much you can afford to borrow: One way to determine that amount is through calculating your debt service cover ratio (DSCR), which can be done through dividing your business’ cash flow by your estimated loan payment. For example, if your cash flow is around $3,000 per month and you calculate the monthly payment on the business loan as $800, your DSCR is 3.75. Generally, lenders will want to see a DSCR of over 1, as if it is lower than 1, that indicates to the lenders that you might not have the funds needed to pay back the loan. Lending sources will be more likely to approve your application if you can prove how you will be paying them back. After figuring out how much you can afford, you can decide which type of financing is right for your business.
Determine the type of loan: Based on your business’ needs, there are several different options to consider including term loans, merchant cash advances, lines of credit, or equipment financing as detailed below:
- Term loans include a fixed amount and a fixed repayment schedule, along with either a fixed or variable rate of interest. Term loans are similar to a mortgage or student loan where an applicant is provided with cash up front and then they pay it back in fixed installments (such as daily, weekly, bi-weekly or monthly) over a set period of time.
- Another option is a merchant cash advance. By definition, a merchant cash advance is not a loan; rather a business to business transaction predicated upon the company’s daily deposit activity. Merchant cash advances provide a short-term funding option for small business owners who were unable to secure financing through a traditional bank. The funds are borrowed against future sales and typically need to be repaid within six months to 18 months.
- A third option is a business line of credit. This is a loan that provides the small business owner with access to a fixed amount of capital in order to help pay for expenses of the business such as inventory, equipment repairs, a new facility, shoring up a gap in cash flow, or to finance a marketing campaign, among many other uses. A business line of credit provides the business owner with quick and convenient access to funds, along with flexible payments and terms. With a line of credit, the business owner is only charged interest on the funds once they are used and interest is only charged on the funds that are used, not the entire amount of the line of credit.
- Equipment Financing offers a quick and simple solution to helping business owners acquire the machinery, tools and materials needed for the company to continue to prosper.
Determine where to secure the funds: Once you have determined the type of financing you would like to take out, the next step is to determine which type of lender you would like to utilize to secure the loan.
- Traditional Banks: Securing a bank loan is ideal if your business has been running for a significant period of time, your credit is strong, and you are not in a hurry to secure the loan. Getting financing through a bank takes longer than other options but will offer more favorable terms.
- Alternative/online lenders: These lenders are ideal if you lack collateral or business experience, or if you need capital quickly. These sources offer loans and lines of credit from $5,000 to over $2 million and funds are typically disbursed within 24 to 48 hours. It should be noted that these notes often include higher rates than compared to a bank.
- Microlenders: These sources will provide options to borrowers with poor credit history (or have no credit at all) or you are new to running a business and are unable to get approval from a bank. Microlenders typically offer smaller loans (usually under $50,000) but include higher rates compared to a bank.
- Credit Unions: Credit unions offer similar financing options than banks, however, these institutions often require a borrower to become a member of the union, then fill out an application form, show proof that you have been in the same job for a certain amount of time, provide income information, while disclosing any debts to the credit union, as your monthly payments on all debt will need to be below a certain debt-to-income ratio, and show creditworthiness. Some credit unions may also require some sort of equity or down payment, depending on the type of loan.
When considering which outlet to utilize to secure financing, it is important to research lending institutions before applying. First, determine whether your current bank offers small business financing that meet your needs. If your current bank cannot help you, research other banks, credit unions and alternative lenders to compare their amounts they can fund, rates, terms, and reputation. Since you will
be working with this lender throughout the course of the note, it will be helpful to ensure you will be able to maintain a positive working relationship with them, so choosing the right lender is very important.
Gather required documents prior to applying: Once you decide which outlet you would like to secure funds through, it should be noted that the application process varies depending on the type of financing and lending source you use. Therefore, it is helpful to have all required documents ready prior to submitting the application in order to ensure a timely process. Documents that are typically required by banks and alternative lenders are detailed below:
- Traditional banks typically require at least 12 months of bank statements, two to three years of the most recently filed tax returns, financial statements (including P&Ls, balance sheets and accounts receivable summaries), details regarding any current and past business loans, legal documents such as articles of incorporation and a formal business plan.
- Alternative/online lenders, on the other hand, require just four months of your business’ current bank statements, your most recently filed tax return and completion of a one page signed application form. Alternative lenders will typically provide a pre-approval within several hours, while banks could take several days or weeks to process the application.
While the application process varies depending on the type of financing and lending source you utilize, it is recommended that you don’t limit yourself to just one option and be sure to shop around to several sources and compare the options you receive in order to ensure you are getting the best possible financing options to fit your business’ needs.
