Debt. Truly a four letter word to most young entrepreneurs. Whether it's the burden they carry with student loans from college, the requirement to sign personal guarantees for business debt or being drilled by anti-debt messages from financial gurus; they are reluctant to consider using debt to help finance their businesses. Did you know that there is such a thing as good and bad debt? Bankers always look to multiple means of repayment when making business loans. They only give loans to people who they are highly confident can repay those loans and understand what makes good or bad debt.
Good debt begins with debt that your business and you can support. This is how bankers make decisions on making loans.
Below are the five characteristics or "c's" of credit, used by many traditional lenders to evaluate small business borrowers.
Cash Flow/Capacity
The first source of repaying is a healthy business with more than enough cash flow to fund the debt. Lenders want to be assured that your business generates enough cash flow to repay the loan in full. This is assessed from financial metrics and benchmarks (debt and liquidity ratios, cash flow statements), credit score, borrowing and repayment history.
Pay down debt before you apply. Also, calculate your cash flow to understand your starting point before heading to the bank.
Character
Banks want to lend to people who are responsible and keep commitments. A lender’s opinion of a borrower’s general trustworthiness, credibility and personality is generally assessed by your work experience, credit history, credentials, references, reputation and interaction with lenders.
If you use a local or community bank, build a relationship.
Capital
The amount of money invested by the business owner or management team is capital. Banks are more willing to lend to owners who have invested some of their own money into the venture. It shows you have some “skin in the game.” Nearly 60% of small-business owners use personal savings to start their business, according to the Small Business Administration.
Keep a record that shows your investment in the business.
Conditions
The condition of your business is whether it is growing or faltering. This also includes what you’ll use the funds for. The state of the economy, industry trends and how these factors might affect your ability to repay the loan are also considered. To ensure that loans are repaid, banks want to lend to businesses operating under favorable conditions. They aim to identify risks and protect themselves accordingly.
You can’t control the economy, but you can plan ahead. Although it might seem counterintuitive, apply for a business line of credit when your business is strong.
Collateral
Finally, bankers will use assets pledged as collateral to pay off business loans, but only as a last resort. Collateral is a backup source if the borrower cannot repay a loan. Hard assets such as real estate and equipment; working capital, such as accounts receivable and inventory; and a borrower’s home can be counted as collateral.
Forming a legal entity helps mitigate that risk.
So, what's the difference between good and bad debt? Well, we covered the good, so now is the bad. There are certainly many instances when taking on debt financing for a business is not a good decision.
For every successful use of credit cards to launch a business, there are dozens who end up with failed businesses and mountains of credit card bills that haunt them for years.
Bankers can tell countless stories of business owners seeking loans to keep their failing businesses afloat. Some debt funds short-term needs for cash, while others fund longer term investments in your business. However, sometimes we use debt for the wrong purpose.
A line of credit is meant to fund short-term timing issues with cash flow, such as funding inventory purchases or paying for payroll on a project that will be billed upon completion. Things that don't take long to generate cash flow.
A good banker can help coach a business owner on the proper uses of lines of credit. At Flagship Bank we can help you with all of your business loan questions. We are here to help you start the next great Minnesota business!
