The ABC's of Borrowing
Summary
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:
(1) credit worthiness, (2)
kinds of loans, (3) amount of money
needed, (4) collateral, (5)
loan restrictions and limitations,
(6) the loan application,
and (7) standards which the lender
uses to evaluate the
application.
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:
1. What sort of person are
you, the prospective borrower? By all
odds, the character of the
borrower comes first. Next is your ability
to manage your business.
2. What are you going to do
with the money? The answer to this
question will determine the
type of loan, short or long-term. Money
to be used for the purchase
of seasonal inventory will require
quicker repayment than
money used to buy fixed assets.
3. When and how do you plan
to pay it back? Your banker's judgment
of your business ability
and the type of loan will be a deciding
factor in the answer to
this question.
4. Is the cushion in the
loan large enough? In other words, does
the amount requested make
suitable allowance for unexpected
developments? The banker
decides this question on the basis of
your financial statement
which sets forth the condition of your
business and on the
collateral pledged.
5. What is the outlook for
business in general and for your business
particularly?
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: (1) the net earning power of the
borrowing company, (2) the
capability of its management,
(3) the long range
prospects of the company, and (4) the long
range prospects of the
industry of which the company is a part.
Such factors often mean
that limitations increase as the duration
of the loan increases.
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:
(1) Repayment terms.
(2) Pledging or the use of
security.
(3) Periodic reporting.
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: (1) protects
position as a creditor
(keeps that position in as protected a
state as it was on the date
the loan was made) and (2) assures
repayment according to the
terms.
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: (1) maintenance of a minimum
net working capital. (2)
carrying of adequate insurance,
(3) repaying the loan
according to the terms of the agreement,
and (4) supplying the
lender with financial statements and reports.
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 your 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.
Cash Budget
(For three months, ending
March 31, 19___)
----------------------------------------------------------------------------
January February March
Budget Actual Budget Actual
Budget Actual
---------------------------
______ ______ ______ ______ ______ ______
Expected Cash Receipts:
----------------------------______
______ ______ ______ ______ ______
1. Cash sales
----------------------------______
______ ______ ______ ______ ______
2. Collections on accounts
receivable
----------------------------______
______ ______ ______ ______ ______
3. Other income
----------------------------______
______ ______ ______ ______ ______
4. Total cash receipts
----------------------------______
______ ______ ______ ______ ______
Expected Cash Payments
----------------------------______
______ ______ ______ ______ ______
5. Raw materials
----------------------------______
______ ______ ______ ______ ______
6. Payroll
----------------------------______
______ ______ ______ ______ ______
7. Other factory expenses
(including maintenance)
----------------------------______
______ ______ ______ ______ ______
8. Advertising
----------------------------______
______ ______ ______ ______ ______
9. Selling expense
----------------------------______
______ ______ ______ ______ ______
10. Administrative expense
(including salary of
owner-manager)
----------------------------______
______ ______ ______ ______ ______
11. New plant and equipment
----------------------------______
______ ______ ______ ______ ______
12. Other payments (taxes,
including estimated
income tax; repayment of
loans; interest; etc.)
----------------------------______
______ ______ ______ ______ ______
13. Total cash payments
----------------------------______
______ ______ ______ ______ ______
14. Expected Cash Balance
at
beginning of the month
----------------------------______
______ ______ ______ ______ ______
15. Cash increase or
decrease
(item 4 minus item 13)
----------------------------______
______ ______ ______ ______ ______
16. Expected cash balance
at
end of month (item 14
plus item 15)
----------------------------______
______ ______ ______ ______ ______
17. Desired working cash
balance
----------------------------______
______ ______ ______ ______ ______
18. Short-term loans needed
(item 17 minus item 16, if
item 17 is larger)
----------------------------______
______ ______ ______ ______ ______
19. Cash available for
dividends,
capital cash expenditures,
and/or short investments
(item 16 minus item
17, if item 16 is larger
than item 17)
-----------------------------------------------------------------------
Capital Cash:
----------------------------______
______ ______ ______ ______ ______
20. Cash available (item 19
after deducting dividends,
etc.)
----------------------------______
______ ______ ______ ______ ______
21. Desired capital cash
(item
11, new plant equipment)
----------------------------______
______ ______ ______ ______ ______
22. Long-term loans needed
(item 21 less item 20, if
item 20 is larger than
item 20)
----------------------------______
______ ______ ______ ______ ______
-----------------------------------------------------------------------
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:
(1) The borrower's debt
paying record to suppliers, banks, home
mortgage holders, and other
creditors.
(2) The ratio of the
borrower's debt to net worth.
(3) The past earnings of
the company.
(4) The value and condition
of the collateral which the borrower
offers for security.
The SBA loan processor also
looks for: (1) the borrower's management
ability, (2) the borrower's
character, and (3) the future prospects
of the borrower's business.
