|
Money Borrowing Basics |
Some small business persons cannot
understand why a lending institution refused to lend them money. Others have no
trouble getting funds, but they are surprised to find strings attached to their
loans. Such owner-managers full to realized that banks and other lenders have to
operate by certain principles just as do other types of business.
This Aid discusses the following fundamentals of borrowing:
Introduction
Inexperience with borrowing procedures often creates resentment and bitterness.
The stories of three small business persons illustrate this point.
"I'll never trade here again," Bill Smith said when his bank refused to grant
him a loan. "I'd like to let you have it, Bill," the banker said, "but your firm
isn't earning enough to meet your current obligations." Mr. Smith was unaware of
a vital financial fact, namely, that lending institutions have to be certain
that the borrower's business can repay the loan.
Tom Jones lost his temper when the bank refused him a loan because he did not
know what kind or how much money he needed. "We hesitate to lend," the banker
said, "to business owners with such vague ideas of what and how much they need."
John Williams' case was somewhat different. He didn't explode until after he got
the loan. When the papers were ready to sign, he realized that the loan
agreement put certain limitations on his business activities. "You can't dictate
to me," he said and walked out of the bank. What he didn't realize was that the
limitations were for his good as well as for the bank's protection.
Knowledge of the financial facts of business life could have saved all three the
embarrassment of losing their tempers. Even more important, such information
would have helped them to borrow money at a time when their businesses needed it
badly.
This Aid is designed to give the highlights of what is involved in sound
business borrowing. It should be helpful to those who have little or no
experience with borrowing. More experienced owner-managers should find it useful
in re-evaluating their borrowing operations.
Is Your Firm Credit Worthy?
The ability to obtain money when you need it is as necessary to the operation of
your business as is a good location or the right equipment, reliable sources of
supplies and materials, or an adequate labor force. Before a bank or any other
lending agency will lend you money, the loan officer must feel satisfied with
the answers to the five following questions:
Adequate Financial Data is a "Must."
The banker wants to make loans to businesses which are solvent, profitable, and
growing. The two basic financial statements used to determine those conditions
are the balance sheet and profit-and-loss statement. The former is the major
yardstick for solvency and the latter for profits. A continuous series of these
two statements over a period of time is the principal device for measuring
financial stability and growth potential.
In interviewing loan applicants and in studying their records, the banker is
especially interested in the following facts and figures.
General Information: Are the books and records up-to-date and in good condition?
What is the condition of accounts payable? Of notes payable? What are the
salaries of the owner-manager and other company officers? Are all taxes being
paid currently? What is the order backlog? What is the number of employees? What
is the insurance coverage?
Accounts Receivable: Are there indications that some of the accounts receivable
have already been pledged to another creditor? What is the accounts receivable
turnover? Is the accounts receivable total weakened because many customers are
far behind in their payments? Has a large enough reserve been set up to cover
doubtful accounts? How much do the largest accounts owe and what percentage of
your total accounts does this amount represent?
Inventories: Is merchandise in good shape or will it have to be marked down? How
much raw material is on hand? How much work is in process? How much of the
inventory is finished goods? Is there any obsolete inventory? Has an excessive
amount of inventory been consigned to customers? Is inventory turnover in line
with the turnover for other businesses in the same industry? Or is money being
tied up too long in inventory?
Fixed Assets: What is the type, age, and condition of the equipment? What are
the depreciation policies? What are the details of mortgages or conditional
sales contracts? What are the future acquisition plans?
What Kind of Money?
When you set out to borrow money for your firm, it is important to know the kind
of money you need from a bank or other lending institution. There are three
kinds of money: short term, term money, and equity capital. Keep in mind that
the purpose for which the funds are to be used is an important factor in
deciding the kind of money needed. But even so, deciding what kind of money to
use is not always easy. It is sometimes complicated by the fact that you may be
using some of the various kinds of money at the same time and for identical
purposes.
Keep in mind that a very important distinction between the types of money is the
source of repayment. Generally, short-term loans are repaid from the liquidation
of current assets which they have financed. Long-term loans are usually repaid
from earnings.
Short-Term Bank Loans
You can use short-term bank loans for purposes such as financing accounts
receivable for, say 30 to 60 days. Or you can use them for purposes that take
longer to pay off--such as for building a seasonal inventory over a period of 5
to 6 months. Usually, lenders expect short-term loans to be repaid after their
purposes have been served: for example, accounts receivable loans, when the
outstanding accounts have been paid by the borrower's customers, and inventory
loans, when the inventory has been converted into saleable merchandise.
Banks grant such money either on your general credit reputation with an
unsecured loan or on a secured loan. The unsecured loan is the most frequently
used form of bank credit for short-term purposes. You do not have to put up
collateral because the bank relies on your credit reputation. The secured loan
involves a pledge of some or all of your assets. The bank requires security as a
protection for its depositors against the risks that are involved even in
business situations where the chances of success are good.
Term Borrowing
Term borrowing provides money you plan to pay back over a fairly long time. Some
people break it down into two forms: (1) intermediate--loans longer than 1 year
but less than 5 years, and (2) long-term--loans for more than 5 years. However,
for your purpose of matching the kind of money to the needs of your company,
think of term borrowing as a kind of money which you probably will pay back in
periodic installments from earnings.
Equity Capital
Some people confuse term borrowing and equity (or investment) capital. Yet there
is a big difference. You don't have to repay equity money. It is money you get
by selling a part interest in your business. You take people into your company
who are willing to risk their money in it. They are interested in potential
income rather than in an immediate return on their investment.
How Much Money?
The amount of money you need to borrow depends on the purpose for which you need
funds. Figuring the amount of money required for business construction,
conversion, or expansion--term loans or equity capital--is relatively easy.
Equipment manufacturers, architects, and builders will readily supply you with
cost estimates. On the other hand, the amount of working capital you need
depends upon the type of business you're in. While rule-of-thumb ratios may be
helpful as a starting point, a detailed projection of sources and uses of funds
over some future period of time--usually for 12 months--is a better approach. In
this way, the characteristics of the particular situation can be taken into
account. Such a projection is developed through the combination of a predicted
budget and a cash forecast.
The budget is based on recent operating experience plus your best judgment of
performance during the coming period. The cash forecast is your estimates of
cash receipts and disbursements during the budget period. Thus, the budget and
the cash forecast together represent your plan for meeting your working capital
requirements.
To plan your working capital requirements, it is important to know the "cash
flow" which your business will generate. This involves simply a consideration of
all elements of cash receipts and disbursements at the time they occur. These
elements are listed in the profit-and-loss statement which has been adapted to
show cash flow. They should be projected for each month.
What Kind of Collateral?
Sometimes, your signature is the only security the bank needs when making a
loan. At other times, the bank requires additional assurance that the money will
be repaid. The kind and amount of security depends on the bank and on the
borrower's situation.
If the loan required cannot be justified by the borrower's financial statements
alone, a pledge of security may bridge the gap. The types of security are:
endorsers; comaker and guarantors; assignment of leases; trust receipts and
floor planning; chattel mortgages; real estate; accounts receivables; savings
accounts; life insurance policies; and stocks and bonds. In a substantial number
of States where the Uniform Commercial Code has been enacted, paperwork for
recording loan transactions will be greatly simplified.
Endorsers, Co-makers, and Guarantors
Borrowers often get other people to sign a note in order to bolster their own
credit. These endorsers are contingently liable for the note they sign. If the
borrower fails to pay up, the bank expects the endorser to make the note good.
Sometimes, the endorser may be asked to pledge assets or securities too.
A co-maker is one who creates an obligation jointly with the borrower. In such
cases, the bank can collect directly from either the maker or the co-maker. A
guarantor is one who guarantees the payment of a note by signing a guaranty
commitment. Both private and government lenders often require guarantees from
officers of corporations in order to assure continuity of effective management.
Sometimes, a manufacturer will act as guarantor for customers.
Assignment of Leases
The assigned lease as security is similar to the guarantee. It is used, for
example, in some franchise situations. The bank lends the money on a building
and takes a mortgage. Then the lease, which the dealer and the parent franchise
company work out, is assigned so that the bank automatically receives the rent
payments. In this manner, the bank is guaranteed repayment of the loan.
Warehouse Receipts
Banks also take commodities as security by lending money on a warehouse receipt.
Such a receipt is usually delivered directly to the bank and shows that the
merchandise used as security either has been placed in a public warehouse or has
been left on your premises under the control of one of your employees who is
bonded (as in field warehousing). Such loans are generally made on staple or
standard merchandise which can be readily marketed. The typical warehouse
receipt loan is for a percentage of the estimated value of the goods used as
security.
Trust Receipts and Floor Planning
Merchandise, such as automobiles, appliances, and boats, has to be displayed to
be sold. The only way many small marketers can afford such displays is by
borrowing money. Such loans are often secured by a note and a trust receipt.
This trust receipt is the legal paper for floor planning. It is used for
serial-numbered merchandise. When you sign one, you (1) acknowledge receipt of
the merchandise, (2) agree to keep the merchandise in trust for the bank, and
(3) promise to pay the bank as you sell the goods.
Chattel Mortgages
If you buy equipment such as a cash register or a delivery truck, you may want
to get a chattel mortgage loan. You give the bank a lien on the equipment you
are buying. The bank also evaluates the present and future market value of the
equipment being used to secure the loan. How rapidly will it depreciate? Does
the borrower have the necessary fire, theft, property damage, and public
liability insurance on the equipment? The banker has to be sure that the
borrower protects the equipment.
Real Estate
Real estate is another form of collateral for long-term loans. When taking a
real estate mortgage, the bank finds out: (1) the location of the real estate,
(2) its physical condition, (3) its foreclosure value, and (4) the amount of
insurance carried on the property.
Accounts Receivable
Many banks lend money on accounts receivable. In effect, you are counting on
your customers to pay your note. The bank may take accounts receivable on a
notification or a nonnotification plan. Under the notification plan, the
purchaser of the goods is informed by the bank that his or her account has been
assigned to it and he or she is asked to pay the bank. Under the nonnotification
plan, the borrower's customers continue to pay you the sums due on their
accounts and you pay the bank.
Savings Accounts
Sometimes, you might get a loan by assigning to the bank a savings account. In
such cases, the bank gets an assignment from you and keeps your passbook. If you
assign an account in another bank as collateral, the lending bank asks the other
bank to mark its records to show that the account is held as collateral.
Life Insurance
Another kind of collateral is life insurance. Banks will lend up to the cash
value of a life insurance policy. You have to assign the policy to the bank. If
the policy is on the life of an executive of a small corporation, corporate
resolutions must be made authorizing the assignment. Most insurance companies
allow you to sign the policy back to the original beneficiary when the
assignment to the bank ends.
Some people like to use life insurance as collateral rather than borrow directly
from insurance companies. One reason is that a bank loan is often more
convenient to obtain and usually may be obtained at a lower interest rate.
Stocks and Bonds
If you use stocks and bonds as collateral, they must be marketable. As a
protection against market declines and possible expenses of liquidation, banks
usually lend no more than 75 percent of the market value of high grade stock. On
Federal Government or municipal bonds, they may be willing to lend 90 percent or
more of their market value.
The bank may ask the borrower for additional security or payment whenever the
market value of the stocks or bonds drops below the bank's required margin.
What Are the Lender's Rules?
Lending institutions are not just interested in loan repayments. They are also
interested in borrowers with healthy profit-making businesses. Therefore,
whether or not collateral is required for a loan, they set loan limitations and
restrictions to protect themselves against unnecessary risk and at the same time
against poor management practices by their borrowers. Often some owner/managers
consider loan limitations a burden.
Yet others feel that such limitations also offer an opportunity for improving
their management techniques. Especially in making long-term loans, the borrower
as well as the lender should be thinking of:
What Kinds of Limitations?
The kinds of limitations, which an owner-manager finds set upon the company
depends, to a great extent, on the company. If the company is a good risk, only
minimum limitations need be set. A poor risk, of course, is different. Its
limitations should be greater than those of a stronger company.
Look now for a few moments at the kinds of limitations and restrictions which
the lender may set. Knowing what they are can help you see how they affect your
operations. The limitations which you will usually run into when you borrow
money are:
A loan agreement, as you may already know, is a tailor-made document covering,
or referring to, all the terms and conditions of the loan. With it, the lender
does two things:
The lender reasons that the borrower's business should generate enough funds to
repay the loan while taking care of other needs. The lender considers that cash
inflow should be great enough to do this without hurting the working capital of
the borrower.
Covenants--Negative and Positive
The actual restrictions in a loan agreement come under a section known as
covenants. Negative covenants are things which the borrower may not do without
prior approval from the lender. Some examples are: further additions to the
borrower's total debt, non-pledge to others of the borrower's assets, and
issuance of dividends in excess of the terms of the loan agreement.
On the other hand, positive covenants spell out things which the borrower must
do. Some examples are:
Overall, however, loan agreements may be amended from time to time and
exceptions made. Certain provisions may be waived from one year to the next with
the consent of the lender.
You Can Negotiate
Next time you go to borrow money, thrash out the lending terms before you sign.
It is good practice no matter how badly you may need the money. Ask to see the
papers in advance of the loan closing. Legitimate lenders are glad to cooperate.
Chances are that the lender may "give" some on the terms. Keep in mind also
that, while you're mulling over the terms, you may want to get the advice of
your associates and outside advisors. In short, try to get terms which you know
your company can live with. Remember, however, that once the terms have been
agreed upon and the loan is made (or authorized as in the case of SBA), you are
bound by them.
The Loan Application
Now you have read about the various aspects of the lending process and are ready
to apply for a loan. Banks and other private lending institutions, as well as
the Small Business Administration, require a loan application on which you list
certain information about your business.
For the purposes of explaining a loan application, this Aid uses the Small
Business Administration's application for a loan (SBA Form 4 not included). The
SBA form is more detailed than most bank forms. The bank has the advantage of
prior knowledge of the applicant and his or her activities. Since SBA does not
have such knowledge, its form is more detailed. Moreover, the longer maturities
of SBA loans ordinarily will necessitate more knowledge about the applicant.
Before you get to the point of filling out a loan application, you should have
talked with an SBA representative, or perhaps your accountant or banker, to make
sure that your business is eligible for an SBA loan. Because of public policy,
SBA cannot make certain types of loans. Nor can it make loans under certain
conditions. For example, if you can get a loan on reasonable terms from a bank,
SBA cannot lend you money. The owner-manager is also not eligible for an SBA
loan if he or she can get funds by selling assets which his or her company does
not need in order to grow.
When the SBA representative gives you a loan application, you will notice that
most of its sections ("Application for Loan"--SBA Form 4) are self-explanatory.
However, some applicants have trouble with certain sections because they do not
know where to go to get the necessary information.
Section 3--"Collateral Offered" is an example. A company's books should show the
net value of assets such as business real estate and business machinery and
equipment. "Net" means what you paid for such assets less depreciation.
If an owner-manager's records do not contain detailed information on business
collateral, such as real estate and machinery and equipment, the bank sometimes
can get it from your Federal income tax returns. Reviewing the depreciation
which you have taken for tax purposes on such collateral can be helpful in
arriving at the value of these assets.
If you are a good manager, you should have your books balanced monthly. However,
some businesses prepare balance sheets less regularly. In filling out your
"Balance Sheet as of ______ 19 ____, Fiscal Year Ends ________," remember that
you must show the condition of you business within 60 days of the date on your
loan application. It is best to get expert advice when working up such vital
information. Your accountant or banker will be able to help you.
Again, if your records do not show the details necessary for working up profit
and loss statements, your Federal income tax returns may be useful in getting
together facts for the SBA loan application.
Insurance
SBA also needs information about the kinds of insurance a company carries. The
owner-manager gives these facts by listing various insurance policies.
Personal Finances
SBA also must know something about the personal financial condition of the
applicant. Among the types of information are: personal cash position; source of
income including salary and personal investments; stocks, bonds, real estate,
and other property owned in the applicant's own name; personal debts including
installment credit payments, life insurance premiums, and so forth.
Evaluating the Application
Once you have supplied the necessary information, the next step in the borrowing
process is the evaluation of your application. Whether the processing officer is
in a bank or in SBA, the officer considers the same kinds of things when
determining whether to grant or refuse the loan. The SBA loan processor looks
for:
The SBA loan processor also looks for: