3 Things You Can Do to Help Your Banker Say Yes

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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Lenders can tell at a glance if your loan application is worth considering. If you know what they're looking for, you can make sure the story is as good as honestly possible.

When lenders look at your application all they really want to know is the answer to three simple questions: Can you pay? Will you pay? and What happens if you don't? The final decision will involve a careful look at the details, but they do that only to confirm and document their original assessment.

The numbers they use to evaluate the Can? Will? and Didn’t! issues are simple ratios you can calculate yourself. The bank's credit department will run your numbers though a program to produce ratios that are based on key income statement and balance sheet numbers. You can dig them out yourself and figure the ratios by just using the calculator on your smart phone.

If you have those ratios and understand what they say about you, you can use our tips to help get the loan you want.

Can You Pay?

What's left over after your bills are paid is a clue your banker uses to tell if you can pay back the loan you’re applying for. But your cash coverage ratio, as it’s called, tells them a bit more.

Use the financial statement your accountant put together for your loan application and find your net income, and add to it your non-cash expenses such as depreciation and amortization. That’s, roughly, your net cash flow. Now divide that number by the annual total of your loan payments, and you have your cash coverage ratio.

Your lender will want that ratio to be 1.5 or higher. If your payments on the new loan totals $20,000 a year, and your net cash flow is $30,000, your cash coverage ratio is about right.

What to Do: If your numbers don’t come out to the 1.5 ratio, another source of cash such as your spouse's or other personal income can make the difference. Be sure to let your lender know if such sources exist if your ratio is close.

Will You Pay?

How you've handled debt in the past, your personal and business credit score, is probably the best indication of how you'll handle it in the future. Your "debt-to-worth ratio," though, tells an important story, too. It tells a lender how much you have at risk, which is a good indication of how much they’ll have at risk if they give you another loan. If you're already using a lot of other people's money (not including investors'), they’ll think twice.

Your ratio of debt-to-worth (also known as debt-to-equity) is easy to figure. Just look at your balance sheet and divide total equity by total liabilities.

Lenders will want to see a ratio that’s no more than three or four times equity. So if you have $100,000 of equity, you should have no more than $300,000 to $400,000 of debt.

What to Do: You can improve your ratio if there's "friendly debt" on your balance sheet. If Uncle Joe is willing to “subordinate” his loan (allow you to pay back the bank before you pay him), your banker may actually treat the debt as equity. You still have to include your debt to Uncle Joe in your application and financials, but if the bank agrees to the idea, treating his loan as subordinated debt could dramatically improve your ratio.

What If You Don't Pay?

But what if the worst happens: your business situation changes and you can’t pay? The bank will want some way to get their money back, and that means they’ll want to know what you have they can sell – the tangible assets that can be liquidated, in banker-speak. Hard assets such as buildings, machinery, and vehicles are usually what they’ll what.

You can use whatever you’re buying as part of the collateral, but it won’t be worth enough to do the job. Here’s why.

If you buy a piece of equipment for $75,000 the lender may assign a collateral value of just $45,000 because if the bank has to sell it, they'll never collect full value. Buy a new car and drive it off the lot, and you’ll have the same problem. Imagine if you’re in the aviation business and you’re pledging collateral that can literally fly away? If you don’t think that can be a problem for a lender watch the Discovery Channel TV show Airplane Repo Man.

Various kinds of collateral have various “collateral valuations,” and your banker will use a range as a guide.

• Accounts Receivable: 20% - 80%
• Inventory: 10% - 80%
• Furniture and Equipment: 10% - 80%
• Real Estate (business or personal): 50% - 90%
• Cash/investments: 50% - 90%

Whether your collateral is valued at the high or low end of the ranges depends on its quality and marketability. In the case of accounts receivable, the quality of your customers, their credit ratings, and their payment histories will determine the collateral value. With inventory, it depends on what it is, where it is, how old it is, and whether anyone wants it.

What to Do: Anything you can do to prove the salability of your assets will help your collateral case. If you can arrange a contingent sale of, say, raw materials, it can help a lot. Be sure your lender knows what you know about the value of your collateral – they will change the valuation if you can convince them it’s worth more than they estimated.

Keep in mind that ratio expectations aren't cast in concrete. If your debt to worth ratio isn’t 1.5 or better, for example, it might be offset by strong cash flow.

To a lender, your ratios are like the jacket copy on a book. If they don't read well, they may not bother to look any further. Calculate the ratios yourself, follow our tips, and you may be able to sell them a lending story they might not have considered otherwise.