It is a common enough occurrence for a business to require a loan or some sort of financing, whether for start-up costs or some other need. Unfortunately, it is also quite common for an entrepreneur to be unprepared for the types of questions and requests for information that they encounter when they approach a financial institution.
The particular reason for you seeking credit will determine the terms and security of the loan. To follow one example, let’s assume a business owner has just found a new market that he wishes to expand into with a new product, and they need to finance working capital and equipment in order to do so.
The business owner believes he has a great new product that will cause his sales to triple over the next three years. Up until now, his business has been financed through a small home equity loan and his own personal funds. As he looks to expand, however, he will need $500,000 to finance working capital (i.e. receivables and inventory) and another $200,000 to purchase new equipment.
Many lenders will ask for a minimum three-year history of earnings and cash flow, with a current financial report and perhaps also a projection for business over the coming year or two. It is also quite likely that they will want to have a Chartered Professional Accounting firm review prior financial statements, or at least issue a Notice to Reader Statement, which is when they offer no assurance regarding the financial statements.
If over the past few years your financial statements have been prepared internally, you would do well to speak to a CPA firm prior to your meeting with the bank in order to find out the time and cost involved in having them issue a Review Engagement or a Notice to Reader report on your prior financials.
In order to secure the loan, banks and other financial institutions will have to assess your available collateral, personal character, your personal net worth as the owner, as well as your corporate and personal tax returns and notices of assessments.
Your company and your personal credit will come under review as well. This is all part of the lender’s due diligence. It may be wise to obtain a personal and corporate credit report in advance. This will allow you to correct any errors before you submit your application for the loan.
Collateral will almost always be required in order to secure the loan, reducing risk of offering credit for the lender. In the case of the example above, asking for $500,000 to cover working capital needs, the bank would ask for security on the company’s accounts receivable and inventory. The usual standard is to lend up to 75% of the corporation’s receivables under 90 days, and in most cases, no greater than 50% of inventory. It is also very common for personal guarantees to be required on loans.
Continuing with the above example, the corporation’s receivables are $350,000, Of that amount, $300,000 is under 90 days, with inventory of $400,000. These would be sufficient amounts for the amount of the loan.
To keep the loan in good standing, an ongoing condition might be that the bank insists upon a monthly aged accounts receivable listing, and an inventory listing once a year or more. Your corporation should have a reliable accounting program and a competent Bookkeeper or Chartered Professional Accountant to generate the required information.
Working capital loans are generally revolving; they can fluctuate on a daily basis, up to the maximum of the loan. They are usually interest only, due on demand. The interest rate is usually variable, at the bank’s lending rate plus anywhere from 1 to 5%, determined by the level of risk involved.
The equipment loan of $200,000 in our example would see the bank attaching security directly on the equipment. These loans are repayable on principal and interest. Often this is done over a period of 3 to 5 years.
Once things are finalized and the loan is in place, the lender will perform an annual year-end review. Banks will typically require annual financial statements with either a Notice to Reader or a Review Engagement report from a CPA firm and is generally required with 90-120 days of the year-end.
The banking agreement will spell out the financial covenants that the corporation needs to have maintained at the end of the year. A CPA will be aware of these covenants and will work with you to avoid breaches, or to correct and account for any that could not be avoided.
Applying for a loan is not a simple procedure. It can be quite complicated, requiring the services of a corporate lawyer to review all documentation from a legal perspective to help you avoid any surprises. Trust your CPA to review all terms and monitor your corporation’s financial well-being to help you avoid going into default.
***This blog is for information only and not to be used as tax advice or planning without first seeking professional advice. Information is subject to change without notice.