By Jim Hingst
Jim Hingst is a contributing writer for Sign Builder Illustrated magazine.
Everyone
needs cash to open a new shop. To fund your business, you can beg and borrow
from your friends and family. You can apply for a loan from a bank or online
lender. Or you can scrimp and scrape until you have enough cash to self-fund
your business. In most cases, that’s your best option.
Asking
your friends or family for a loan often seems like the easiest and least
painful choice for startup money. While you may have the best of intentions and
your family may be willing to help, don’t do it. As Polonius advised his son in
Hamlet: “Neither a borrower nor a lender be;/ For loan oft loses itself and
friend.” If you fail to pay a loan back, the lender loses his money and you
lose a friend. What’s worse, is the shame of losing money that your family
loaned you. When that happens, you might as well pack your bags for parts
unknown.
The
Advantages of Self-Funding. According to Mark Cuban,
“only a moron starts a business on a loan.” That may seem a bit harsh. However,
Cuban has a point. Your best bet is to save your money and fund it yourself.
Start out small. And live within your means.
As
you are building a nest egg, another great piece of advice is “don’t quit your
day job.” As you are working for your employer, prepare for the opening of your
business. Unless there is a conflict of interest, you might consider starting
your business on the side. This will give you time to build your customer base
and build a nest egg until you are ready to go it alone.
If
you are working for someone else, devote your spare time to learning your
business better than anyone else. As Mark Cuban says, the primary reasons
people fail are stupidity and laziness. If your competitors know the business
better than you do, they will eat your lunch. The key is not only to work
harder than the next guy, but also to work smarter.
In a
perfect world, self-funding your business is generally great advice for
startups. However, in the real world,
many entrepreneurs who launch a new business need to borrow money at some
point. That may not be for a of couple years because banks typically don’t fund
startups.
On
the other hand, banks generally view new ventures favorably if the owners
self-fund the business during the first years. It tells the lender that you
believe in yourself and your vision for the business. Why should anyone else
invest in your shop, whether it is a bank, your family or your friends, if you
aren’t willing to put your personal money at risk.
As a
business owner, you have to deal with tremendous pressure at work. Taking on a
loan can subject you to additional pressure that can affect your physical and
mental health. If you have a family, your relationships can also suffer.
To
make matters worse, if you fail to make a payment, it can affect your credit
score, making it difficult to secure additional funding, not only for your
business but also to get loans for a home or car.
Taking
out a loan may seem easier and provide more advantages than self-funding. In
most cases, you would be wrong. The main disadvantage is that you must pay back
the loan with interest.
To
make matters worse, failure to repay a loan opens you up to liability. If you
have set up your business either as a sole proprietorship or as a partnership,
you are personally responsible for failure to repay your business loans. In
these cases, lenders can seize your business assets as well as personal assets
such as furniture, cars and even your home, to cover any debts that your shop
accumulates.
Your
best financing option is to self-finance. That means that you need to save
enough money to get started. What’s more, it also means that you will probably
start out small. That’s OK. If you work harder and smarter your business will
probably survive.
By
financing your own business, you avoid the additional pressure of making loan
payments. It gives you more time to worry about your shop operations and
marketing your services instead of worrying about the money you owe someone
else.
Types
of Business Loans. Lenders provide many different types of
business loans to small businesses. Each type has advantages and disadvantages.
Which type of business loan is appropriate for you relies on several factors.
Most importantly, the right loan for you depends on what you need it for. Other
factors include how quickly you need the money and for what period of time.
Some of the types of funding available include business term loans, SBA loans
and a business line of credit.
Business
Term Loans. If you are looking to expand your business,
a business term loan can provide you with a lump sum of cash to fuel your
enterprise. This standard loan covers a fixed “term” or specified period of
time, usually between one and five years. The term for buying real estate can
be as long as 25 years. Over the life or term of the loan you will make fixed
installment payments.
Business
term loans are generally used to purchase long-term assets, also called fixed
assets, such as real estate, shop equipment and vehicles. This is not the type
of loan that you will use to buy short-term assets, such as inventory.
Getting
approval from either a bank or online source is generally easier and faster
than other types of loans, if your business is well-established and has a good
credit rating. When applying for this type of loan you should have all of your
financial statements, tax returns and bank statements available for the lender.
Prior
to applying for a loan, check your personal and business credit rating. Lenders
use credit scores as a barometer of the likelihood that you will pay back the
loan on time. FICO (Fair Isaac Corporation) is one brand of score. The rating
ranges from 300 to 850. The higher the
credit score, the better. Banks use this rating in determining whether or not
to grant a loan, as well as deciding the credit limit and interest rate for the
loan.
Your
business may also have a credit rating, especially if your company has borrowed
money in the past or has been issued a business credit card. Your payment
history with utility companies or with any vendor or distributor who has
extended you credit, will likely affect your credit score.
While
you can use term loans to obtain larger amounts of financing, you very likely
will need collateral, such as real estate or equipment, to secure this type of
funding. Loans from online sources are usually faster than getting a loan from
a bank, but interest rates are typically higher.
SBA
Loans. The SBA or Small Business Administration is not a
lender. Instead, this government agency works with banks and other lending
institutions to help small businesses obtain SBA-guaranteed loans. In the loan
approval process the SBA sets the guidelines, although the lender usually has
some of their own credit policies.
There
are many different types of SBA loans. More than 75% of these are 7(a) loans.
Within the 7(a) category are several variations of loans such as the 7(a) Small
Loan and the SBA Express Loan.
A
SBA 7(a) loan can fund a wide range of business activities. These include
purchasing equipment, business expansions, acquisitions, buying real estate or
providing your company with working capital.
What
makes these loans attractive are the loan rates, which are some of the lowest
rates on the market. These rates range from prime +2.25% to prime +4.75%.
The
repayment terms for 7(a) loans can also be attractive. Repayment for equipment
is up to 10 years. Loans for working capital can be as long as 7 years. Down
payment for an SBA loan may also be significantly lower than with a
conventional loan. In addition, fewer fees, if any, may apply.
The
downside of an SBA loan is the qualification process. A standard loan can take
as long as 6 weeks for approval. In some cases, it can take months.
The
length of time for the loan approval sometimes depends on whether you are
dealing with a preferred lender or not. A preferred lender, which includes most
major banks, can make its own credit decisions.
On the
other hand, a non-preferred lender acts as a go-between you and the SBA. For
this reason, the qualification process, when using a non-preferred lender, can
be quite lengthy.
Your
chances of getting a 7(a) loan are about 65%, which is typically better than
getting a regular bank loan. To qualify for a loan, you will need a good credit
score (over 650) and have been in business for a minimum of two years. You will
also need to put up collateral for the loan and sign a personal guarantee.
Business
Line of Credit. It doesn’t matter how big your shop is,
sometimes the spaghetti just hits the fan and you run into a cash flow problem.
For that reason every company should establish a business line of credit with
their bank.
The
line of credit gives you the flexibility to write checks so you can buy
inventory, pay operating expenses and make payroll. It is not intended to
finance the purchase of real estate or shop equipment.
The
line of credit is a type of short-term loan that covers your checks when the well
temporarily runs dry. To cover the amount needed, the bank charges you an
interest fee. Generally, this fee is at a much lower interest rate than other
types of loans because it is comparatively low risk.
New
businesses are generally required to secure a line of credit using personal
assets such as real estate as collateral. If you have a partner, both of you
will most likely need to put up personal assets as collateral.
Until
your shop becomes financially stable, some will banks extend your company an
unsecured line of credit. In most cases, to get a business line of credit
without a personal guarantee, your shop needs to have been in business for a
couple of years, have strong revenues and an outstanding credit report.
As
an alternative to traditional banks, you can also get a business line of credit
from online alternative lenders. These institutions have different practices
for evaluating your credit worthiness. Alternative lenders will check your
banking activity, and have different standards for the revenue that your shop
generates.
Generally,
you can get approved for an online business line of credit much faster than
going to a bank. Make sure that you investigate the repayment terms as well as
all of the fees that an alternative lender may charge you, such as an
inactivity fee.
Business
Credit Card. If you don’t have a business credit card,
you should get one. Then make sure that you pay off the balance each month in
full. This helps improve your business credit rating. A good rating increases
your chances of getting a loan at a good interest rate.
Before
applying for a business credit card, compare the advantages of the different
cards. Your comparison should include spending limit, interest rate, rewards
and annual fee. Generally, business credit cards have higher credit limits and
lower interest rates than personal credit cards. Business credit cards also
have some great perks, such as memberships in airline lounges.
In
selecting a business credit card make sure that it reports to the major credit
bureaus: Dun & Bradstreet, Experian and Equifax. One of the best cards is
the American Express Business Platinum Card®. At $595, the annual fee is high
compared to other cards.
Equipment
Leasing. When acquiring new equipment such as a wide format
printer, one of your key decisions is whether to buy or lease. One advantage
when leasing is no down payment is required. What’s more, at the end of the
lease term you can either buy the equipment at a discount or you can upgrade to
the next latest and greatest technology.
Equipment
Financing. Financing business equipment is a type of business loan
that is strictly used for buying equipment.
This type of loan is not quite as difficult to obtain as other types of
loans, because the equipment you are buying is in itself collateral for the
loan. That way it is less of a risk for the lender.
If
you are borrowing money for equipment, explain to the lender exactly what type
of equipment you want to buy or lease, its cost and why it is important for
your business.
Tangible
assets, whether they rapidly become outdated or not, depreciate over time. In
some cases, leasing makes more sense than purchasing – if the equipment has a
relatively short lifecycle. For example, it may be wiser to lease digital
printing equipment because the technology changes quickly.
In
financing equipment, lenders look at three key factors, your credit score,
annual revenue and the length of time in business. Because the equipment serves
as collateral for the loan, you may qualify for financing even if your credit
score is less than ideal.
However,
if your business is a startup or you have been in business for fewer than two
years, getting approval for a loan may be difficult. Lenders may also require a
down payment before approving financing an equipment purchase.
When
deciding whether to buy or not to buy, these are the questions you should ask:
• Is
the equipment a necessity for staying competitive in your market?
•
What increase can you realize in employee output?
•
How will the equipment improve the quality of your finished goods?
•
What improvement in sales and profits will you generate?
•
How long will it take to pay for the equipment?
An
advantage to leasing is that lower initial cash is required. What’s more,
leasing packages will occasionally cover maintenance. In some cases, lease
payments are tax deductible. However, depreciation of leased equipment is not
deductible.
When
buying equipment your best option is to pay cash and avoid the headaches
involved in the loan process. Of course, that usually isn’t practical. Paying
cash depletes your working capital, which is the money you have on hand to pay
your current financial obligations. These obligations include paying vendors
and utility bills along with paying your employees.
If
you are considering paying cash when buying equipment, you need to estimate whether
you will have sufficient cash following the purchase. To determine your working capital needs you
should track your monthly inflows and outflows of cash. With this data you can
anticipate sales and expense trends.
The
5 Cs of Business Credit. In the approval process for business
loans, lenders use the five Cs of credit as their standard for credit analysis.
If you want to improve your chances of getting a business loan, you need to
satisfy the requirements in these five areas. The five Cs are:
•
Capacity
•
Capital
•
Character
•
Collateral
•
Conditions
Capacity. In
rating a business’s capacity to repay a loan lenders generally evaluate the
company’s Cash Flow Statement for at least two years. Startups, on the other hand, need to prepare
a projection of its cash flow for the first year. An evaluation of cash flow
statements will reveal whether your business generally has enough cash to repay
its loans.
In
addition to your cash flow statement, your lender will want to know what
personal sources of income you could use to make payments, such as checking and
savings accounts or even your spouse’s income.
Character. In
deciding whether to approve your loan application, bankers will assess your
“character.” This has a little less to do with your personal integrity than it
refers to your credit score and creditworthiness.
Improving
Your Business Credit Score. A less than desirable credit score
dooms more than one-third of small business loan applications, or results in
less than the funding requested. Two factors, which greatly affect your credit
score are an existing high level of debt and having an insufficient credit
history.
Lenders
use your personal and your business credit scores as a measure of your ability
and willingness to pay back a loan. Before you apply for a business loan,
examine your personal and business credit scores.
Lenders
also view your past credit history as a barometer of future financial success.
From the viewpoint of a lender, a low credit score equates to high risk. Consumer
credit scores are based on a mathematical model, which estimates the risk of
someone going 90 days late on a payment during a two-year period. FICO scores range
from 350 to 850. Lenders view scores above 750 favorably.
Business
credit scores are connected to your company’s EIN (Employer Identification
Number). Banks use credit scores from different reporting agencies, such as Dun
and Bradstreet, Experian and Equifax. The models used for business credit
scores predict the chances that your business will run 90 days late within a
year. Some scoring systems also forecast the possibility of your business
encountering a financial catastrophe.
The
D&B score is called the PAYDEX score.
D&B bases their score on how promptly you have paid your vendors
over the last two years. PAYDEX scores range from 0 to 100. Anything above 80
is a great rating. D&B also provides a rating of your company’s financial
condition.
Some
credit risk scores used a blended system which evaluates both your personal and
business credit history. For example, SBA uses the FICO Small Business Scoring
Service (SBSS) as a basis approving for all SBA 7(a) loans. FICO SBSS scores range from 0 to 300. Loans
are rejected for any score below the 160.
Many
other factors are used in developing a credit score. These include the number
of years in business, company assets, revenue and cash flow. The best way to
improve your credit score is to pay your bills on time.
In
determining how much credit a bank will extend to your business, they will
check whether you have maintained a minimum daily balance of $10,000 for the
last 90 days. Banks will also look at frequency of deposits and the age of your
account.
Some
of the factors that credit agencies and banks use are within your control.
Others are not. In some cases, credit ratings take into consideration your
industry and general economic conditions. You can’t control external financial
considerations, so only focus on those components that you can influence.
Based
on the information in your financial documents a lender will also make a number
of critical calculations to ascertain the health of your company. These
assessments include:
•
Debt-to-Income (DTI) or Sales Ratio
•
Debt Service Coverage Ratio (DSCR)
•
Debt Ratio
While
these financial evaluations are often critical in loan approval, you should
also utilize them as financial key performance indicators in managing your
business.
Debt-to-Income.
Banks need to reduce their risks. To assess the ability of a business to repay
their loan, lenders use a number of financial metrics. One of these measures is
debt-to-income or sales ratio. Debt to income describes a relationship between
what a company owes versus its revenue. A rule of thumb is that your DTI should
not be higher than 45%.
Monthly
Debt ÷ Monthly Income = Debt-to-Income Ratio
$85,000
Monthly Debt ÷ $290,000 Monthly Income = 29.3% Debt-to-Income Ratio
Debt
Service Coverage Ratio. The Debt to Income (DTI) and Debt
Service Coverage Ratio (DSCR) are similar but not the same. Banks use the DTI
for home loans. They use the DSCR for commercial loans.
The
Debt Service Ratio is usually (but not always) calculated over a year. It
compares your net operating income to your debt service for a specified period.
Debt
Service. Your annual debt service covers all of your payments on
your loans for company vehicles, real estate and shop equipment. This includes
both the principal and the interest for all outstanding loans. In many cases,
debt service will be listed as an expense on your income statement, which makes
it easy for a lender to identify it.
To
calculate the DSCR divide your Annual Net Operating Income by your Annual Debt
Service Payments. Your operating income equals your revenues minus Cost of
Goods Sold (CGS) and Shop and Administrative Expenses. As a rule of thumb, the
minimum DSCR value required for a bank to approve a loan is typically 1.25 or
125%.
Revenues
– (CGS + Shop & Administrative Expense) = Net Operating Income
Annual
Net Operating Income ÷ Annual Debt Service Payments = DSCR
Example:
$1,080,000
Net Operating Income ÷ $500,000 Debt Service Payments= 2.16 or 216% DSCR
Debt
Ratio. Using your balance sheet, a lender can calculate your
debt ratio. Your debt ratio compares your total debts (liabilities) to total
assets. For example, if your liabilities are $200,000 and your assets are
$450,000, your debt ratio is 44.4%.
$200,000
Total Debts ÷ $450,000 Total Assets = 44.4% Debt Ratio
In
evaluating your character, a lender may check how much experience you have in
your field, your reputation in the marketplace and may even ask for references.
Today lenders may also check public reviews in assessing your trustworthiness.
Capital.
Banks may also check the amount of money that you personally have invested in
your business. Lenders generally believe that if you personally have “skin in
the game” you will more likely repay the loan. As a rule of thumb, banks like
to see that the owner’s personal investment in their business is at least 25%.
Collateral.
When
you are starting a business, one of the worst options for financing is a bank
loan. You take a big risk when you take out a loan because you commit to paying
the loan back on a schedule.
Collateral
is an asset that you (as a borrower) pledge as security to obtain a loan. When
you default on a loan the bank can seize the assets that you used as collateral
to recover their losses.
To
secure a business loan, you can use the following assets:
•
Commercial property
•
Vehicles
•
Shop tools and equipment
•
Inventory
•
Accounts receivables
•
Cash
•
Personal property
Conditions. You
can control some factors of your business destiny, but other factors are beyond
your control. In approving your loan application, banks will take into
consideration many of those conditions you cannot control. These include the
effect of inflation on the economy. Many predict that we could be heading into
a recession in 2022. Lenders will also evaluate the conditions within your
market and your competitive environment.
In
addressing these conditions your business plan should expound upon the opportunities
available, as well as the numbers of competitors and the threats that they pose
to your shop. Your plan should also
include your sales and marketing strategy and how you would respond to an
economic downturn.
Additional
Loan Requirements. If your business is a sole proprietorship or
a partnership, each owner will likely need to provide personal financial
statements in applying for a loan. What’s more, the owners may need to assume
personal responsibility, in writing, for the loan. The reason is that sole
proprietorships and partnerships are “pass-through entities.”
A
pass-through entity is structured so that profits pass through the business to
the individual owners. That way, the business does not incur income taxes.
Instead, the owners do. The advantage is that you, as an owner, avoid double
taxation. That’s why, more than half of businesses are set up as pass-through
entities.
Lenders
often require owners of sole proprietorships and partnerships to provide
personal financial information, such as social security numbers, assets (real
estate, vehicles, etc.), mortgages, credit cards and tax returns. Your bank may
not require this financial information for loans less than $50,000.
If
your business is a limited liability company (LLC) or corporation, your bank
will likely require that you submit business tax returns for loans over
$50,000.
Insurance
Policies. To mitigate their risks in approving a loan to a new
business, the bank may also require the primary owners to take out life
insurance policies listing the bank as the beneficiary in the event of a death.
Tax
Returns. To verify the accuracy of your financial documents, your
lender will most likely require copies of your corporate tax returns. They will
use the returns to ensure that there are no discrepancies with your financial
records.
Receivables.
Many sign shops require a 50% deposit upon placement of the order with the
balance to be paid upon delivery of the graphics. That’s ideal because you
don’t have to deal with receivables.
If you extend credit to your
customers, your lender may insist on seeing an aging report. You can easily
track your receivables using an Excel worksheet. The aging report allows you to
classify receivables based on how long an account is outstanding. In formatting
a worksheet, you need columns listing the invoice date and the due date agreed
upon in the sales contract. With this information you can organize receivables
according to 30, 60 or 90-days overdue. Lenders will use this information to evaluate
the financial health of your business.
When
selling large graphics or signage programs, payment terms are usually extended.
That means that you will carry the amount due on your books. This can
complicate your bookkeeping and your life. Not only does it add to your
liabilities, you must keep track of your receivables on an accounts receivable
aging report and, in many cases, chase after your money. Collections are often
a time-consuming and unenviable task. It takes persistence and tact. Very few
people are good at it.
At
the very least you need to review your accounts receivable aging report
monthly, if not sooner. Receivables are assets, which you can record on your
balance sheet. They are valuable to your business because you can turn them
into cash. Once the receivable is paid,
you list them as cash.
Sales
History. Although it is not so important as cash flow, lenders
often examine your sales history for the past two or three years. They will
check for any trends of growth or decline.
UCC
Liens. The Uniform Commercial Code (UCC) is a set of laws covering
commercial transactions accepted by all states. As part of a business loan,
lenders may require that you agree to a UCC lien. The lien protects the lender
in the event that the borrower defaults on the loan or files for bankruptcy.
The
lien establishes priority in recovering payment for debts. The document is
filed with the Secretary of State and covers a period of five years. The lender
must refile the lien after it expires to reestablish their rights to priority.
If
there are multiple UCC liens on your business, priority is determined based on
the dates of filing. After you have
completely repaid a loan, you should request that your lender notify the
Secretary of State to terminate the lien.
Pro
Forma Financials. In applying for a loan the lender may
request that you provide pro forma financial documents: income statements,
balance sheets and cash flow statements. Banks may request pro forma financials
as evidence of your capacity to repay a loan.
As a
business owner, a pro forma can help you make an educated decision when making
an investment in your company. It is a projection of how your business will
perform in the future. You can use pro forma financials to predict the
financial impact on your shop when making an investment in new equipment,
opening a new location or hiring new employees.
In
fact, pro forma financials are nothing more than a best guess. In making a
business decision you can compare projections of what might happen if you do
make an investment to what might happen if you don’t.
Pro
forma financials are only as good as the reliability of your inputs. As the
saying goes, garbage in, garbage out. Financial projections are often suspect
because they are frequently used to paint a rosy picture. After all, the person
creating the financials is trying to convince lenders that they should approve
the loan application.
For
this reason, when you submit pro forma financial statements, be prepared to
support your assumptions as your lender scrutinizes your projections.
In
making your projections, you may base them on a number of assumptions, such as
sales and fixed expenses will increase 15% annually or that your Cost of Goods
Sold (COGS) will remain a constant 20% of revenue. Using these assumptions, you
can make your calculations. Here’s how a bare bones pro forma income statement
might look:
|
Pro Forma Income Statement for Projected Years 2022, 2023 & |
||||
|
|
2021 Actual |
2022 |
2023 |
2024 |
|
Revenue (15% Annual Increase) |
$500,000 |
$575,000 |
$661,250 |
$760,437 |
|
COGS (20%) |
($100,000) |
($115,000) |
($132,250) |
($152,087) |
|
Shop & Administrative Expenses |
($150,000) |
($172,500) |
($198,375) |
($228,131) |
|
Depreciation |
($15,000) |
($15,000) |
($15,000) |
($15,000) |
|
EBIT (Earnings Before Interest & Taxes) |
$235,000 |
$272,500 |
$315,625 |
$365,219 |
|
Interest Expense |
($30,000) |
($30,000) |
($30,000) |
($30,000) |
|
EBT (Earnings Before Taxes) |
$205,000 |
$242,500 |
$285,625 |
$335,219 |
|
Taxes (21%) |
($430,050) |
($50,925) |
($59,981) |
($70,396) |
|
Net Income |
$161,950 |
$191,575 |
$225,644 |
$264,823 |
Defaulting
on Loans. During the pandemic
thousands of businesses defaulted on their loans. It doesn’t matter whether the
loan is secured or unsecured, defaulting usually results in major repercussions
for your shop.
If you
have a secured loan and cannot meet your financial obligations, your lending
institutions can seize the assets that you put up as collateral. Defaulting on
a loan has other ramifications such as it usually damages your credit rating.
This will hamper your ability to borrow money in the future.
In the
case of an unsecured loan, you were not required to put up collateral. If your
business is a sole proprietorship, your lender could come after your personal
assets in order to recover their money. On the other hand, if your shop is set up
as an LLC (limited liability company), the owners are protected to some degree
against defaults.
Difficulties
in Paying Back Loans. If you find yourself in a financial hole, many shop
owners secure a loan to solve the dilemma they are in. The mistake that they
make is thinking that they can borrow their way out of debt.
If you are
having problems paying back a loan, talk to your lender. They may be willing to
propose a solution before you default. One possible solution is to request
lower payments for a time until you are in a better financial position.
Your
Liability for Business Debts. How your business is
organized, such as a sole proprietorship, partnership, LLC or corporation, can
affect your personal liability. If your
shop is organized as a sole proprietorship, you and your business are one in
the same. That means that if your business defaults on a loan, you are
personally responsible. Your creditors
can come after your personal assets to recoup their losses. Which assets the
bank can take varies from state to state.
In a partnership, both partners are also
personally liable to pay the business’s debt. That does not mean that partners
necessarily split the liability 50:50. If your partner is destitute, and you
own a home, car and other assets, you may be stuck holding the proverbial bag.
Organizing your business as an LLC
generally affords you more protection from personal liability in the event that
you default on a loan. It is, after all, called a limited liability company. Of
course, there are exceptions. If you used company funds to purchase an RV or a
boat for personal use, your personal assets are most likely at risk. Another
exception is if you used a personal asset to secure a loan.
Reasons Loan Applications Are Rejected. The primary reasons for loan rejections are
insufficient collateral, poor credit rating and high expenses in relation to
revenues. To improve your chances of getting a loan, you can take the following
steps:
• Create a business plan
• Provide sufficient collateral
• Improve your credit rating
• Reduce your shop and administrative
expense
• Increase revenues
How to Write a
Business Plan for a Commercial Loan.
If you decide to go to your bank and secure a business
loan, you need preparation. To plead your case, you need to prepare a business
plan, complete with financial records and projections. If you are opening a new
shop, you will also need an estimate of your startup costs.
The Importance of a Business Plan. According to the business axiom, failing
to plan is planning to fail. That’s only good advice if you take it.
Unfortunately, many new small business owners never take it. Fewer than 45% of small businesses
create a formal business plan. Of those that do, about two-thirds of their
business owners acknowledge the plan contributed to the success of their
companies.
Not having a business plan is
one reason that 20% of startups fail within the first year of operation. That’s
really not too bad when you consider that after five years, half of the businesses
have closed their doors. By the 10th year 90% have failed.
Your business plan is your
blueprint for creating a successful business. Develop
a comprehensive plan that address key opportunities and threats. It also requires that you understand your
strengths and weaknesses as well as those of your competitors. As Sun Tzu
explained in The Art of War: “If you know the enemy and know yourself,
you need not fear the result of a hundred battles.” By creating a comprehensive
business plan outlining your strategies and tactics, you will maximize your
chances for success.
Taking the time to develop a
solid business plan also helps
in securing a business loan. Lenders analyze an
applicant’s business plan to determine the chances of a new venture succeeding.
Without a sound plan, the odds that you will get approval for a loan are slim.
A business plan should answer how your shop will
overcome the primary reasons for failure. The three key reasons that account
for 90% of business closures are:
•
Marketing Problems
•
Financial Problems
•
Personnel Problems.
Your business plan must focus on these three areas of
your business. In the financial section of your
business plan, lenders not only want to review several years of past financial
statements, they also want to evaluate future projections.
The
sales and marketing section is critical because problems in this area account for
the majority of business failures. Banks want to examine your market analysis,
product and service offerings, sales and marketing plan and threats from
competition.
The
third most important segment of your business plan is your key personnel. This should list the primary managers in your
shop, their responsibilities and summaries of their experience.
Based
on the information in your business plan, your bank will determine the
likelihood that your shop will be successful and whether or not you will have
problems repaying the loan.
As you are composing your business plan, think of
it as your company’s resume to secure a loan. With this in mind, write your
business plan to address the 5 Cs of Business Credit: Capacity, Capital, Character, Collateral and
Conditions.
The business plan explains
your company goals as well as your strategy for growing your business. It also
includes financial projections for the upcoming years. What’s more, the
business plan explains why you need the loan and how you plan to pay back the loan.
Your business plan should
describe the opportunities available to your company. It should delineate the
unmet needs in your market and how your shop can satisfy those needs. To best
outline those needs, you should survey a significant sample size of your target
market. That means investing in the time to interview prospects and
customers.
After portraying the
problems or pain points that prospects and customers endure, present how your
product offerings and services provide a solution. In other words, define your unique selling proposition which I cover in an earlier article.
Your business plan should also
portray in detail your target market and market potential. You should explain
the range of product offerings and advantages your shop provides. In addition, your plan should outline your
competitors. It should describe their strengths and weaknesses as well as the
challenges that they pose to your business.
As
important as a business plan is in securing a business loan, it is just as
critical as a roadmap of how you will run your company. You can find templates
for business plans on the internet. Most
of these formats are very similar in that each is divided into basic company
operations.
Typical
sections in a business plan include:
•
Executive Summary
•
Business Description
• Competitor
Analysis
•
Market Analysis
•
Marketing and Sales Plan
•
Product Offerings and Services
•
Financial Projections
•
Funding Request
Executive
Summary. Some lenders may not want to read your
entire business plan. The executive summary condenses your plan to a one-page
abstract. It is similar to a lawyer’s opening statement at the beginning of a
trial. Keep it short and sweet. Save the details for the body of the business
plan.
In
the executive summary you should briefly describe your company and your
products and services. It explains your target market and the unmet needs of
your prospects. Your summary also describes your primary competitors, what
differentiates your shop from these rivals and why your business will be
successful.
With respect to your loan request, your summary
should spell out how much money you need, what you need the money for and how
much time you need before you realize a return on the investment.
Business Description. Your
company description provides an overview of your business – who you are and
what you do. In a few sentences you should concisely cover the basics. You can
provide the details in the remainder of the plan.
The basics
should include:
• the name
under which you operate in your state
• the business
structure (whether it is a sole proprietorship, partnership, LLC or
corporation)
• a list of
your company’s key managers
• your mission
statement
• your target
market
• the range of
products and services that you provide
• your company
goals.
Market Analysis. The
market analysis section of your business plan demonstrates to lenders that you
know your market. What’s more, the opportunities are significant enough to
sustain your business. In delineating the opportunities, you should cover the
following topics:
• Market Potential.
Quantify the size of the current market size in dollars and cents. Provide a projection for future market growth,
which you could base on industry studies. You should also explain how you
collected the data on your market. Using the internet, you can compile some
basic information on your market, your prospective customers and the
competition. However, for in-depth research, you will need to conduct phone and
in-person surveys. Other sources include interviews with your salespeople,
vendors and business associates. Market research should be an on-going
endeavor.
• Target Market.
Describe your ideal target customer, such as private carriers with fleets less
than 50 vehicles. In surveying your market, you should quantify how many of
these fleets are domiciled in your region.
• Unmet Market Needs.
Describe any products and services which competitors do not provide. Then
explain how your shop satisfies any of these unmet market needs. Also define your unique selling proposition.
• Barriers to Entry.
Barriers preventing a new competitor from opening a shop protect you from
losing a share of your market. They also protect a lender’s investment. These
barriers include skills that take years to learn. List those skills that
prevent a new competitor from doing what you do.
• Competitor Analysis. Writing
the competitor analysis section of your business plan requires research. You
can conduct your initial research on the internet. For more detailed
information, vendors are a good source. As a word of caution, be careful in
sharing information about your shop with talkative salespeople.
You can also learn about
your competitors’ production capabilities, pricing and marketing efforts from
employment interviews and from talking to their customers.
Based on the information you
collect you can analyze your competitors. After identifying their strengths and
weaknesses you should describe your strategy for competing with them. Explain
how your shop can satisfy the unmet needs in your market or how you can serve
an overlooked market segment.
• Sales Analysis. To
accompany the sale revenue reported in your income statements, you should
chronicle your actual month by month sales performance against your goals. Your
business plan should also include a sales budget for the upcoming years based
on the trends in past performance.
Some of the metrics you should track and
include in your business plan include month-to-month sales, the number of
accounts added to your database, 30-60-90 day rolling forecast, and the number
of face-to-face sales calls from month-to-month.
You
should use the data of past performance to explain the opportunities within
different segments of your business, such as fleet graphics or tradeshow
graphics. In your report, you should also provide any insights about product
offerings and where you are underperforming.
Use
of graphs in your sales analysis can demonstrate your awareness of your market,
your customer base and your opportunities, as well as understanding of the
hurdles that confront your shop.
Based
on your sales analysis, you should also describe any modifications to your
sales and marketing strategies to address any changes in buying behavior,
competitive challenges or impending economic storms on the horizon. Keep in
mind that a company’s inability to recognize or respond to changing market
conditions is one of the main reasons that new businesses fail.
• Marketing and Sales Plan. More than half of all business failures
result from poor marketing. That’s why market research is so important. In the
sales and marketing section of your business plan you need to demonstrate a
thorough understanding of your market and how your products and services will
fulfill the unmet needs of your prospective customers.
•
Financial Analysis. In
qualifying for a loan, bankers will concentrate on the financial analysis
portion of your business plan. This section should include three-year financial
projections as well as historical records covering the past three to five
years.
Lenders use this information
to judge the financial strength and profitability of your shop as well as to
determine your ability to repay a loan. This section of your business plan
should include three key statements:
• Income Statement
(also known as a Profit & Loss Statement or P&L)
• Balance Sheet
• Cash Flow
Statement
Income
Statement. The income statement helps lenders as well as company
owners evaluate the performance of the business against its goals and past
performance. It summarizes your shop’s income and expenses over a period of
time. The difference between the two is your profit or, in some cases, your
loss:
Revenue
– Expenses = Profit or Loss
The income
statement provides measurements in key areas:
sales, cost of goods sold, gross profit margin, shop and administrative
expense, returns and allowances, operating margin, and net profit. See my article on key performance indicators.
As a
management tool, a shop owner can use this information to determine the
performance of his managers in various areas of the business, including sales,
administration, costing and production. Variances from one time period to
another in these key areas can help owners spot trends as well as trigger
warnings of potential problems.
An historical
record of growth in sales and profit along with responsible control of expenses
provides lenders with critical information needed in the loan approval process.
Lenders will look at trends in annual revenue as a key indication of the
strength or weakness of your business.
Balance Sheet.
Balance sheets
are typically computed at the end of a financial period. It provides a snapshot
of your finances at a single point in time versus an accounting of what
transpired over a financial period.
The balance
sheet consists of three parts: assets, liabilities and equity. Assets
are what you own. Liabilities, on the other hand, are what you owe. The
difference between assets less liabilities is your equity.
Assets =
Liabilities + Equity
Assets
are listed on the left-hand side of the balance sheet. An asset could be cash
or a cash equivalent. It could also be the real estate the company owns, office
equipment, furniture, accounts receivables, inventory or shop equipment. In
recording an asset on your balance sheet, its cost or what you paid is shown rather
than its market value or what you could sell it for.
Assets
are listed in two categories. Current assets are what you can turn into
cash within a year. This includes cash, receivables and inventory. Noncurrent
or fixed assets are those items, which you will not convert into cash
within a year. These are assets that you will use for more than a single
accounting period. Fixed assets include office equipment, vehicles, real estate
and shop equipment. These assets are often referred to a PP&E or Property,
Plant and Equipment.
|
Balance |
||||
|
Assets |
|
Liabilities |
||
|
Current Assets |
Current Liabilities |
|||
|
Cash and Cash Equivalents |
$10,570 |
Accounts |
$15,932 |
|
|
Receivables |
$42,853 |
Short-term |
$2,390 |
|
|
Inventory |
$25,089 |
Other |
$0 |
|
|
Other Current Assets |
$0 |
Total Current Liabilities |
$18,322 |
|
|
Total Current Assets |
$78,512 |
Long-Term Liabilities |
||
|
Fixed Assets |
Long-Term Debt |
$321,600 |
||
|
Real Estate |
$350,000 |
Other Long-Term Liabilities |
$0 |
|
|
Vehicles |
$59,000 |
Total Long-Term Liabilities |
$321,600 |
|
|
Shop Equipment |
$127,000 |
Total Liabilities |
$339,922 |
|
|
Goodwill |
$0 |
|
||
|
Other Fixed Assets |
$0 |
Equity |
||
|
Total Fixed Assets |
$536,000 |
|
|
|
|
Total Assets |
$614,512 |
Total Owner Equity |
$277,590 |
|
$614,512 Total
Assets = $339,922 Total Liabilities + $277,590 Total Owner Equity
Liabilities. Liabilities
and Equity are listed on the right-hand side of the balance sheet. The total of
liabilities and equity must equal assets. That way, each side of the balance
sheet balances out.
Liabilities
include Accounts Payable, Wages Owed, Interest Owed on Loans, Taxes Owed and
Benefits Payable. Just as there are different categories of assets, there are
different classifications of liabilities: Current Liabilities and Long-term
Liabilities. Current liabilities must be paid within a year. Long-term
liabilities, on the other hand, are paid over a longer period.
The Importance of the Balance Sheet. For both business owners and lenders, the
balance sheet is the financial canary in the coal mine. If the ratio of your
liabilities greatly outweighs your assets, your business is headed for a bad
day at Black Rock. To avoid bankruptcy, you need to take drastic corrective
action.
Generally,
when assets are greater than liabilities, your business is growing. On the
other hand, when liabilities are greater than assets, your company is dying.
Debt-to-Equity
Ratio. As you review your balance sheet
you should evaluate your business’s debt-to-equity ratio. This financial key
performance indicator ascertains your company’s capability to pay its
debts.
Total
long-term and short-term debt/Total owner equity = Debt-to-equity ratio
Example:
$323,990
Total Debt/$277,590Total Equity=1.167 D/E ratio
The D/E
ratio in the above example is less than enviable. Yet, it is not uncommon for
new companies.
Two
other line items that lenders will focus on are cash and receivables. The
balance sheet helps lenders determine if you have enough cash on hand to pay
your interest expense (listed on your income statement). Lenders may view high
receivables as a red flag indicating a collections problem. This is why a bank
may want to see an aging report. Generally, unpaid balances should not exceed
90 days.
If your business does not have enough cash, lenders want
to determine how reliant you are on generating a steady stream of sales to pay
your bills. If your shop depends heavily on monthly sales to cover your
expenses, you may not be able to withstand competitive challenges or downturns
in the economy.
Caveat Emptor. If you are
taking out a loan to buy a franchise or an existing business, you might
encounter the term “goodwill” as you review the assets on a balance sheet. For
most of us this is a confusing financial concept.
In many cases, some of what you are purchasing is
not something tangible, such as production equipment or real estate. Instead,
some of what you may be paying for is an intangible asset called “goodwill.” An
intangible asset is an asset that you cannot sell but nevertheless has some
value. This could be the brand name of a franchise or its reputation in the
marketplace. If you are buying another shop, goodwill could also be the value
of its customer base or an experienced workforce.
The problem with an intangible asset such as
goodwill is that it is difficult, if not impossible, to quantify. That means
that, in the event of a business failure, how can you liquidate a brand name or
customer list?
Cash
Flow Statement. The movement of cash in and out of a
business is called cash flow. According to many studies, problems managing cash
flow result in more than 75% of business failures. A cash flow statement
providers a lender with an overview of how well you manage your cash.
If
you do not have enough cash on hand, you cannot pay your bills, you cannot pay
your employees and you cannot buy more raw materials to conduct operations.
Your business is dead in the water. In other words, you are bankrupt. This is
why lenders will carefully examine your cash flow statement in conducting a
financial analysis of your company.
Good
bookkeeping practices are essential in maintaining good cash flow. Failure to
attend to your accounts payables and receivables commonly cause cash flow
problems and can result in poor financial decisions. See
my story on cash flow problems.
As
your business is starting up you can experience periods when you are strapped
for cash. Expenditures on new equipment and increased inventory can result in
more cash going out than is covered by sales and collection of receivables.
The standard format for a cash flow statement summarizes
financial transactions within your shop. The statement divides these
transactions into three different financial categories:
• Operating Transactions. This section is the most
important part of any cash flow statement. It covers the day-to-day inflows and
outflows of cash within your business. Sales transactions, for example, are
inflows. Paying your employees, paying your utility bill or purchases of raw
materials are cash outflows.
Operating transactions are computed in one of two ways,
either the direct method or the indirect method. The indirect method is the
easiest to understand and the more commonly used.
• Investing Transactions. These activities cover
the purchase and sale of long-term assets. This includes transactions, such as
buying or selling of a boom truck, computers, furniture or a digital printer.
• Financing Transactions. Financing transactions
cover activities involving long-term liabilities, such as raising money through
business loans or repayment of debt principal.
At the bottom of the cash flow statement is the
reconciliation section. It begins with the cash balance from the previous
financial period. It ends with the balance from the current financial period.
The difference between the beginning and ending balances is the net change in
cash. This net change in cash must equal the net cash in the operations,
financing and investing sections.
|
Cash Flow Statement For Year |
|
|
Operating |
Amount |
|
Net Income |
$133,250 |
|
Accounts Receivables (Invoices not yet |
($50,000) |
|
Accounts Payables (Bills not yet paid) |
$25,000 |
|
Net |
$108,250 |
|
|
|
|
Investing |
|
|
Payments to Buy Property, Plant & |
($30,000) |
|
Cash from the Sale of PP&E |
$10,000 |
|
Net |
($20,000) |
|
|
|
|
Financing |
|
|
Owner’s Investment |
$0 |
|
Owner’s Withdrawal |
($30,000) |
|
Net |
($30,000) |
|
|
|
|
Net |
$58,250 |
|
Opening |
$25,000 |
|
Closing |
$83,250 |
Funding Request. You should write the funding request as a
stand-alone document. Even though you have already provided a business
description in your business plan, you should recap it in this section. Your
description should explain your target market, business structure, standing in
the market and current financial position.
Your
funding request should describe why you need the loan. In other words, explain
how will it improve your business. To help your chances of loan approval, try
to quantify the expected return on investment. If you plan to use the money for various
things, provide an itemization.
Addendum.
At the end of your business plan, you can include appropriate additional information.
This may include support materials that your bank has requested, such as tax
returns, real estate documents and marketing materials.
Conclusion. As important as a
business plan is as a blueprint for running a successful shop, it is also a
critical tool in qualifying for a loan. Write your plan with the intention of
persuading a lender that you are very knowledgeable about your market and the
competition that you face. What’s more,
you have a thorough plan that satisfies an unmet market need, which ensures the
success of your business.
According to Greg
McKay, VP of Earl Mich Company, preparing a business plan is essential for any
new business. It improves your odds for success and it helps avoid failure. To
this end he reminds us of the six Ps: Proper Prior Planning Prevents Poor Performance.
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