10 Things the Bank Will Ask When You Need a Business Loan | LivePlan

Key takeaways

Banks require significant collateral, often including personal assets, to secure commercial loans.
Loan applications necessitate a detailed business plan, comprehensive financial statements, and personal financial information from owners.
Expect to provide extensive documentation on accounts receivable and payable, tax returns, and agree to future financial ratios.

That bank loan you want for your company? Well, the bank is going to want a lot from you before they decide you’re worth funding.

Do you find this daunting? Me too. I was really disappointed when I needed my company’s first commercial bank loan for Palo Alto Software to finance receivables of more than $1 million — from well-known distributors no less — and we ended up having to sign a lien on our family home to get the loan.

We said, “Wait, we’re a corporation, why do we need personal guarantees?”

They said, “If you don’t believe in your business, then we don’t, either.”

We said, “Wait, these are good receivables, you already checked the credit ratings of these distributors, why aren’t they enough?”

They said, “If you don’t believe…(see above).”

And at that point I realized the truth in the old cynical joke that says banks will lend you money only if you don’t need it.

One of the first things overly-optimistic entrepreneurs discover as they look for funding is that banks don’t just fund great business plans. They fund businesses that have a plan, have clearly identified a market opportunity and demonstrate the ability to execute on that opportunity. And, most importantly, have assets to guarantee the loan.

In lenders’ defense, it would be against banking law if they funded a business just because it submitted a well-written business plan. Banks are dealing with depositors’ money, after all. Would you want your bank to invest your checking account balance in a startup? I wouldn’t. And neither would U.S. banking regulators.

So here’s what to expect a bank to ask for when you apply for a commercial loan for your business, as well as a few “do’s” and “don’ts” to keep in mind when applying for a business loan. There will be occasional exceptions to every rule, of course, but here are some general rules:

1. Collateral

As I explained above, banks do lend money to startups, but typically not just on the strength of your business plan – you’ll have to have some form of collateral to guarantee the loan, such as a house.

One exception to the rule is that the federal Small Business Administration (SBA) has programs that guarantee some portion of a loan for startup costs for new businesses. This makes it easier for banks to lend startups money because the government is guaranteeing a portion of the loan, therefore reducing the bank’s risk.

So, you or your business has to have hard assets it can pledge to back up a business loan. Banks look very carefully at these assets to make sure they reduce the risk. For example, when you pledge Accounts Receivable to support a commercial loan, the bank will check the major receivables accounts to make sure those companies are solvent; and they will accept only a portion, often 50% or sometimes 75%, of receivables to back a loan. When you get an inventory loan, the bank will accept only a percentage of the inventory, and they will do a lot of due diligence first, to make sure it isn’t old and obsolete inventory.

The need for collateral also means that most small business owners have to pledge personal assets, usually house equity, to get a business loan.Read more:The 5 C’s for making your business credit-worthy

2. Business plan

There are exceptions, but the vast majority of commercial loan applications require a business plan document. Nowadays it can be short — perhaps even a one-page business plan — but banks still want that standard summary of company, product, market, team, and financials.

3. All of your business’s financial details

That includes all current and past loans and debts incurred. It also includes all bank accounts, investment accounts, credit card accounts, and of course, supporting information including tax ID numbers, addresses, and complete contact information.

4. Complete details on Accounts Receivable

That includes aging, account-by-account information (for checking their credit), and sales and payment history.

And if you don’t know what your Accounts Receivable are, then count your blessings. If you had any, you’d know.

5. Complete details on Accounts Payable

That includes most of the same information as for Accounts Receivable and, in addition, they’ll want credit references, companies that sell to your business on account that can vouch for your payment behavior. If you need to know more about Accounts Payable, just read our guide that explains things simply.

6. Complete financial statements, preferably audited or reviewed

The balance sheet has to list all your business assets, liabilities and capital, and the latest balance sheet is the most important. Your Profit and Loss statements should normally go back at least three years, but exceptions can be made, occasionally, if you don’t have enough history. But you do need to have good credit and assets to pledge as collateral. You’ll also have to supply as much profit and loss history as you have, up to three years back.

Regarding audited statements, having “audited” statements means you’ve paid a few thousand dollars to have a CPA go over them and take some formal responsibility for their accuracy. CPAs get sued over bad audits. The bigger your business, the more likely you’ll have audited statements ready as part of the normal course of business for reasons related to ownership and reporting responsibilities.

Having statements reviewed is a lot cheaper, because the CPAs who review your statements have way less liability if you got it wrong. Banks won’t always require audited or even reviewed statements because they always require collateral, so they care more about the value of the assets you pledge.

7. All of your personal financial details

This includes social security numbers, net worth, details on assets and liabilities such as your home, vehicles, investment accounts, credit card accounts, auto loans, mortgages, the whole thing.

For businesses with multiple owners, or partnerships, the bank will want financial statements from all of the owners who have significant shares.

And yes, as I implied in the introduction to this article, that’s leading to the personal guarantee. Expect to sign a personal guarantee as part of the loan process.

8. Insurance information

Since it’s all about reducing the risks, banks will often ask newer businesses that depend on the key founders to take out insurance against the deaths of one or more of the founders. And the fine print can direct the payout on death to go to the bank first, to pay off the loan.

9. Copies of past returns

I think this is to prevent multiple sets of books — which I think would be fraud, by the way — but banks want to see the corporate tax returns.

10. Agreement on future ratios

Most commercial loans include what we call loan covenants, in which the company agrees to keep some key ratios — quick ratio, current ratio, debt to equity, for example — within certain defined limits. If your financials fall below those specific levels in the future, then you are technically in default of the loan.

5 Do’s and Don’ts When Applying for a Business Loan

So now you have a sense of what to expect from a bank if you’re thinking about applying for a loan.

But what about choosing the right type of loan for your business? After all, it can be difficult to navigate the myriad loan options available to small business owners. Conventional bank loans, SBA loans, online working capital loans, and peer-to-peer loans are just a few of the types of loans that small businesses are eligible for.

But there are certain factors to look out for to make sure you’re getting the right kind of loan and aren’t overpaying. Here are five pointers to keep in mind when searching for a business loan.

1. Limit the number of loans you apply for

When you’re just starting out in your search for a business loan, it can be tempting to apply for as many loans as possible in the hopes that something will stick. However, such an approach can hurt your credit score, making it harder to qualify for a loan.

Every time you apply for a business loan, the lender will check your credit. In some cases, such as when getting an initial quote, the lender will do a soft credit pull, which won’t affect your credit score.

However, when you submit a full application, the lender will do a hard credit pull. This can dent your credit score by a few points for each application. Sometimes, even getting an initial quote can trigger a hard credit pull.

The wisest approach is to first find out different lenders’ qualification criteria and apply strategically for the two or three options that you’re most likely to qualify for. Also, be sure to ask the lender about its credit check policies, so you’re not caught by surprise.

2. Understand the cost of the loan

Lenders describe the cost of a loan in different ways. Some will tell you the interest rate on the loan, and others may tell you the total amount of money you have to pay back. When lenders describe loan costs in different ways, it makes it difficult to compare your loan options.

To make comparison shopping easier, ask the lender to tell you the Annual Percentage Rate (APR) of the loan.

APR, a term you may be familiar with if you’ve bought a home or car, is the total cost of a loan over one year, including fees. The APR of a bank or SBA loan varies based on factors like interest rates, fees and the total loan amount. It can be much higher for alternative lenders that provide fast funding and work with lower credit borrowers.

Keep in mind that a low APR loan isn’t necessarily better than a high APR loan. Short-term loans often have high APRs, but since they are paid off quickly, you’re not paying interest for a long time. As a result, the total amount of money that you have to pay back is relatively low.

3. Be wary of prepayment penalties

While on the topic of cost, prepayment penalties can be a trap for an unwary borrower.

A prepayment penalty is a fee that a lender charges if you pay off a loan before the due date. By paying a loan off early, you reduce the amount of interest that the lender earns on the loan, so they charge a penalty. The fee can be a percentage of the outstanding balance of the loan, or it can be on a sliding scale, where the earlier you pay, the higher the penalty will be.

Not all loans have prepayment penalties; for example, standard SBA loans don’t have prepayment penalties. When shopping for a loan, you may also be able to negotiate the removal or reduction of a prepayment penalty. If not, read the fine print before signing the loan agreement so you understand exactly how much you will be charged for prepaying a loan.

4. Choose between a line of credit and a traditional loan

Depending on your business needs, a business line of credit may be a better option than a loan.

A loan is a fixed amount of money that you pay back with interest over a specific period of time; a line of credit is like a credit card. You get approved for a maximum amount of money that you can access as needed, and you repay it over a period of time. The advantage of a line of credit is that you only have to pay interest on the funds you use.

A line of credit is better than a loan in two main cases. If you occasionally need short-term working capital to buy inventory or cover seasonal expenses, a line of credit gives you flexibility. A line of credit also provides a nice safety net to cover unexpected business expenses. But loans typically work better when you need to finance a long-term investment, such as equipment or real estate.

5. Understand which assets are at stake if you can’t pay back the loan

Most lenders will not give a loan to a business (especially a startup) unless it’s secured by collateral, a lien, or a personal guarantee. This shouldn’t be taken lightly. Valuable personal and business assets may be at stake if you don’t pay back the loan, and you should understand what’s on the line.

Loans may be backed by specific collateral (e.g. property, equipment, inventory, and so on), or by a general lien on your business assets. When a loan is backed by specific collateral, you give the lender the right to seize that collateral if you can’t pay back the loan. If a loan is backed by a general lien, then the lender can take any or all business assets to satisfy an unpaid loan.

Even a loan with no collateral or liens may require a personal guarantee. This allows the lender to seize your personal assets, such as your home and car, if you’re unable to pay back the loan.

Bottom line

There are a lot of things to consider when you are trying to obtain a business loan, and it can seem overwhelming. But following the tips above will help you assess the basics of your loan options and avoid making a big mistake, like pledging your house as collateral without understanding what that means.

Ultimately, every business is different, and every business needs financing for different reasons. With that in mind, it’s best to ask a trusted advisor and your lender all of your questions before committing to a loan.

A business loan is a big commitment, so you’ll want to cover your bases and make sure you know exactly what you’re getting and what you’re paying for it.

Home

10 Things the Bank Will Ask When You Need a Business Loan