Many small businesses rely on small business loans to finance growth opportunities and other profitable initiatives. Unfortunately, it has become increasingly difficult for small businesses to qualify for bank rate financing. According to the latest 2019 PCA Index Survey Responses Trend Analysis, only 31% of small businesses were able to secure working capital through small business bank loans.
So, why do smaller companies find it more challenging to qualify for financing?
- Less profit on smaller loan amounts. According to a study by Harvard Business School, more than 70% of small business owners apply for loans under $250,000, and more than 60% want loans under $100,000. It doesn’t make financial sense for banks to lend money to these businesses because it costs just as much to underwrite a million-dollar loan as it does a $250,000 loan.
- Increased regulation. Banks had to reassess their risk appetite after the 2008 recession. Since smaller businesses are inherently riskier borrowers compared to larger companies (thanks to the lack of collateral, fewer years in business, and/or poor credit rating), banks think twice about approving their applications.
- Lack of credit history and collateral. Lenders usually require collateral to secure a loan, which can pose a problem for companies that don’t have valuable assets to offer. Lenders also evaluate a business’ credit history to determine their creditworthiness. This may be challenging for newer companies that don’t have an established credit history.
Applying for small business loans is overwhelming, but it isn’t impossible. The secret to securing working capital comes down to your preparedness. Here’s a list of tips you should remember before applying for a small business loan:
1. Pinpoint Exactly Why You Need a Loan
When lenders entrust a significant amount of money to your business, they’ll want to know how you’re going to spend it. This makes perfect sense because how you invest the loan will affect your bottom line, and therefore, your ability to repay the loan.
Some of the most common reasons for seeking small business loans include the following:
- Managing day-to-day expenses
- Building a cash buffer for unexpected expenses
- Hiring more employees
- Taking advantage of business opportunities
- Launching a marketing campaign
- Expanding your product/service lines
- Renovating your space
- Upgrading equipment
- Purchasing inventory
- Increasing working capital
2. Determine Which Type of Loan Works Best for You
When applying for a loan, you want to make sure you’re choosing one that works best for your specific company needs. This tip goes hand in hand with tip #1 – take time to evaluate your business and know why you need a loan. If you need to buy more inventory, inventory financing may be the ideal solution. For more details about inventory financing, check out SMB Compass.
Here’s a list of financing options for small businesses:
- Business Line of Credit
- SBA Loans
- Equipment Financing
- Asset-Based Loans
- Business Term Loans
- Inventory Financing
- Invoice Financing
- Purchase Order Financing
- Bridge Loans
3. Know How Lenders Assess Your Application
Lending companies have their own criteria for assessing small businesses and those businesses’ ability to repay the loan. Generally, lenders look at these five factors when evaluating an application:
- Collateral. Valuable assets (real estate, inventory, invoices, vehicles, equipment, etc.) that can secure the loan in case of a default.
- Cash flow. The higher the profit you generate (and the better you are at managing it), the lower the loan risk.
- Credit score and credit history. This will show whether you’ve repaid loans and debts on time or if you haven’t. The lower the credit score, the lesser your chances of approval are.
- Industry. High-risk industries like gambling, cannabis, mining, etc. may have a harder time qualifying for a loan. From a lender’s point of view, companies that belong to high-risk industries are more likely to fail.
- Time in business. Lenders favor companies who have been in business for several years. If you’re new, it helps to have an executable business plan for reaching short-term and long-term business goals.
There’s a good chance your small businesses won’t excel in all five areas, but if it’s strong in at least three, lenders should consider your application.
4. Check Your Business and Personal Credit Scores
Your business and personal credit scores determine your creditworthiness, meaning, your ability to repay the loan. Naturally it’s one of the first things lenders will examine. They will view your credit history as it pertains to both personal payments (mortgage, credit cards, car loans, etc.) and business obligations (past/other loans, vendor contracts, credit cards, etc.).
According to Experian, a good credit score is at around 700+. A score of 800 or more is considered excellent. You can check where your credit scores stand by visiting Equifax Business, Experian Business or Dun & Bradstreet.
If your credit rating is less than stellar, you can improve your scores by paying your bills on time, paying off debt and keeping your balances low on any revolving credit. Don’t apply for too much credit as this can create several hard inquiries on your credit profile and negatively affect your score.
5. Prepare Important Documents
To hasten the application process, familiarize yourself with the type of documents you’ll need to present on behalf of your business. Be prepared and organized. Lenders often ask business owners to submit the following documents:
- A detailed business plan
- Business and personal financial statements
- Business and personal credit report
- Business and personal tax returns
- Business forecast
- Business registration and licenses
- Legal documentation, such as commercial leases, articles of incorporation, etc.
6. Provide Collateral If Necessary
Whatever loan you choose, a lender’s biggest concern is your ability to repay it. To lower the risk on their part, they may ask you to provide collateral, such as: property, commercial real estate, company equipment and accounts receivable, among others. Lenders have the right to seize and sell your assets if you fail to repay the loan. Using a high-value asset to secure the loan increases your chances of qualifying and getting more favorable terms.
If you don’t have any assets or you don’t feel comfortable using one, you have the option to apply for an unsecured business loan. As the name suggests, these loans don’t require collateral but lenders may charge higher rates to offset the added risk.
Final Thoughts on Applying for a Small Business Loan
Securing a small business loan from the bank can be challenging, but alternative lenders provide a myriad of other financing programs more easily available to you. Do your research and be prepared. Know what type of financing best fits your specific needs and what the requirements are to be approved for said option. If you’re planning to apply for a loan, be sure to refer to the tips outlined above and increase your chances for approval.