File C5-95 December 2009 www.extension.iastate.edu/agdm Obtaining a Business Loan

orrowing money is a requirement of almost too large or too small for some lenders. The lender every business regardless of whether it is may not have any experience funding your type of Ba start-up or an on-going business. In the business. Most start-up businesses need lenders who discussion below, we will identify many of the fac- understand their unique situations. tors you should consider in creating and maintain- ing a lender/borrower relationship. First we will Make a professional loan request discuss ideas for creating a relationship with your When applying for a loan be prepared to present all lender. Next we will examine the loan request from aspects of your request so the lender can make an the lender’s perspective. Finally we will identify informed and accurate decision. Put in writing what reasons why credit lines get in trouble. you want to do. This may involve preparing a busi- ness plan. Establishing a Relationship with a Lender All business owners - whether their businesses are Apply for the loan early large or small, well-capitalized or operating on a Don’t wait until you need funds to apply for the shoestring - should develop a working relationship loan. This puts pressure on the lender and increases with their primary lender. the likelihood of loan rejection. Making a loan request well in advance of the need for funds shows However, remember that the lender’s fi rst responsi- the lender you have good planning skills. bility is the fi nancial health and profi tability of the lending institution, just as your fi rst responsibility Establish a credit history is to your business. You would not jeopardize your Borrow funds for short periods and repay promptly business to save the lender, so don’t expect the to establish a track record of proper loan repayment. lender to jeopardize the lending institution to save your business. Get to know your lender Invite your lender to visit your business. Introduce The type of relationship we are discussing here is an the lender to your employees. arms-length business relationship between you and the lender. Your expectation should be that the only Keep your lender informed way the relationship will continue is if the relation- Share your plans for the future. For a start-up ship is in the best interest of both parties. venture, the new business will need to have a fully developed business plan to share with the lender. There are a number of steps the borrower can take to Included in this business plan must be a clear indica- develop a relationship with the lender. The following tion of how the business will be fi nanced. The plan are offered as suggestions: must show how the management team will make the business successful. Select the proper lender Shop around to fi nd the right lender. Lenders have Don’t surprise your lender certain types of loans and businesses they like to If you foresee repayment problems, tell your lender work with and other types they prefer not to fund. right away. There may be a solution and the lender Find out what types of loans and customers each can be a helpful resource. Lenders would rather re- lender is interested in serving. Your business may be structure loans for repayment than have to foreclose on the loan.

Don Hofstrand extension value-added ag specialist co-director Ag Marketing Resource Center 641-423-0844, [email protected] Page 2 File C5-95

A Lender’s Perspective on Making a Loan 4. Track record – Does the individual have a track Over the years, fi nancial lenders have developed record of successfully starting new businesses or several simple approaches to assessing the feasibil- did past attempts fi zzle? Does the borrower have ity of making a loan. These approaches can be used a track record of loan repayment? regardless of the type or size of business involved. If you are planning to ask for a loan, use the follow- The Loan ing factors as a checklist to improve your chances of 1. Returns (cash fl ow) – Will the use of the loan getting the loan. The process will identify weakness- funds create suffi cient returns (cash) to repay es that can be corrected before you ask for the loan. the loan? Remember that the returns must fi rst cover all of the costs associated with the project Getting approval for a loan is a good thing, get- or business before funds are available for loan ting rejected may be even better. Even after going repayment. You may need to create a cash-fl ow through this exercise, the lender may reject your loan budget to show how the loan funds will create request. However, don’t take the rejection person- suffi cient cash fl ow to meet the loan principal ally. The lender is in the business of making loans. and interest payments. It is also important that But something in your request caused the rejection the timing of the cash fl ows correspond to the of your loan. Talk to the lender and ask why the loan repayment schedule. If the loan will not loan was rejected. The lender may have identifi ed create an income stream, describe and document how the loan will be repaid. a weakness in your business that can be corrected before it causes major problems down the road. 2. Risk - What can go wrong with the project or business? What is the probability that something The discussion below examines the lender’s perspec- will go wrong? Is the business suffi ciently capi- tive of the borrower, the business, the loan itself talized to handle risk? What risk management and the circumstances surrounding the loan and the strategies are available to help mitigate the risk? business. Are there contingency plans in place to mitigate risk? Are there alternative sources of cash from The Borrower which payments can be made? 1. Competency – Does the individual have a thor- ough understanding of the market and industry in 3. Collateral – Lenders often want protection in which he/she will be competing? Does the bor- case of default on the loan by the borrower. The rower have industry contacts and know the indus- lender may use the property being purchased as try players? Does the individual have experience collateral for the loan. Additional collateral may in starting and running a business? be required as well as a personal guarantee by the borrower or other representative. 2. Character – Does the individual display char- acteristics of honesty and integrity? Borrowers The Business should present themselves as upstanding, respon- 1. Track record – If this is an existing business, sible members of the community and be able to what has been the fi nancial track record of the back up this claim with references. Borrowers business over recent years? Does the business also need to show they can be trusted to be up- model seem viable and profi table? Have sales front and transparent about problem areas. increased? Has equity grown?

3. Commitment – Is the individual committed to 2. Leverage – Can the business take on additional the business ventures and willing to do what is debt and maintain a reasonable debt-to-asset necessary to make it successful and repay the ratio? Is the business positioned to adequately loan? meet its loan repayment requirements along with covering the other fi nancial demands of the busi- ness? File C5-95 Page 3

The Circumstances Business too small 1. Industry - The state of the industry in which The business may be too small to generate suffi - the borrower will operate is also important to cient income for family living needs. The shortfall the lender. Is it a new and expanding industry is often covered by short-term borrowing. However, or a mature and stable one? The lender will be the accrued debt makes the income defi ciency even interested in who your competitors are and your greater. strategies for competing with them.

Failure to analyze the business 2. General economy – What are the conditions of Debt repayment capacity is based on the ability the general economy at the time of the loan re- of the business to generate income and cash fl ow. quest and the projected state of the economy for Failure to accurately analyze the income, expenses, the coming several years (during the repayment and cash fl ow of the business may lead to errors in period of the loan)? Are there societal trends that projecting debt repayment capacity. will affect the viability of the business and loan repayment capacity? Will impending regulations Unrealistic prices and production levels create problems? Unrealistic assumptions may lead to errors in analyz- ing the repayment capacity of a loan. Typical errors Why Credit Lines Get in Trouble pertain to estimates of selling prices and production There are many reasons why credit lines get in or sales levels. However, poor assumptions about trouble. The following listing can be used as a effi ciency factors are also common. diagnostic tool to identify the cause of a credit line problem. Solutions can be developed once problems The borrower may intentionally use unrealistic as- have been identifi ed. The listing can also be used as sumptions in order to obtain or keep a line of credit. a prevention tool to identify potential weaknesses However, the use of unrealistic assumptions can before they become a problem. also be unintentional. The borrower may not have suffi cient business records or outlook information to Failure to supervise the loan realistically describe the business. Failure to supervise the loan by either the lender or the borrower is a common cause of credit problems. Lack of partial budgeting The loan should be monitored on a regular basis to Partial budgeting involves projecting the added costs insure that it will be properly repaid. Loan supervi- and added returns from a capital investment. Unless sion is not the responsibility of just the lender but is partial budgeting or a similar procedure is used to also in the best interest of the borrower. estimate the additional income generated from the loan funds, the repayment capacity may fall short. Lack of communication Just because an business decision involves new tech- Successful loan repayment is often based on open nology or is common among other farmers does not discussion between lender and borrower. Lack of mean that it is profi table or fi nancially feasible. communication and trust by either party often results in a breakdown of the business relationship. Uncontrolled living expenditures Many small business owners are negligent about Ineffi cient business monitoring and controlling family living expendi- To generate suffi cient income for debt repayment, tures. Monitoring expenditures involves keeping the business must be well managed and achieve pro- records of the money spent for family living. Keep- duction effi ciencies. To avoid repayment problems, ing the business and family fi nancial transactions the lender may want to monitor business and produc- in separate checking accounts will often be helpful. tion effi ciency. Successful control of family living expenditures Page 4 File C5-95

often involves developing and monitoring budgets of grow until it jeopardizes the health of the business. expected family living needs. Carryover debt is often too large to be repaid during one production period. It may need to be paid over a Lack of business direction period of years. Progress should be made each year The planning horizon for many small business own- in retiring carryover debt. ers is often one production period. So, the business lacks any long-term goals or direction. This lack of Poor risk management long-range business planning is often accompanied A cash buffer should exist between the projected by a lack of progress on long-term debt repayment. repayment ability of the business and the business debt repayment schedule. For example, if the debt Failure to structure repayment repayment schedule is based on the repayment If possible, the repayment terms of the loan should ability in an average year, a shortfall will occur in be tied directly to the additional income generated low income years. This shortfall is often covered by from the loan. Unless the loan repayment is struc- borrowing additional money. Due to this additional tured and the additional income designated for loan debt, the total debt load cannot now be serviced in repayment, the income will be spent elsewhere and average years. the debt carried over from year to year. Poor use of profi t windfalls Repaying debt too rapidly An abnormally profi table year often provides ad- Reducing debt as quickly as possible is often a good ditional income. However, the additional money is objective. However, trying to repay debt too rap- often consumed or used to purchase non-productive idly may unnecessarily cause a shortage of cash for assets rather than repaying debts. As a result, when operations. The length of debt repayment should be below average years occur in the future, there is no tied to a conservative estimate of the life of the as- reserve for debt payments. sets the borrowed funds were used to purchase. Using multiple credit sources Purchasing capital assets with cash Farmers often obtain credit from a variety of sourc- Using cash reserves to purchase capital assets may es. Usually the larger the number of credit sources result in cash shortages in the future. Suffi cient cash the more diffi cult it becomes to monitor overall debt should be maintained to cover intermediate and repayment. Consolidating credit and reducing the long-term debt payments, income taxes, family liv- number of sources may improve the ability to suc- ing expenditures, and other items. cessfully project and monitor debt repayment.

Buying non-productive assets Ignoring tax consequences Using borrowed funds to purchase non-productive Although interest payments are tax deductible, assets requires the repayment to come from other principal payments are not. Debts must be repaid sources. The alternative repayment sources should with after-tax income. This calculation needs to be be carefully identifi ed in advance. included in the debt repayment analysis.

Carryover debt Selling assets to repay debt may also have signifi - Short-term loans that cannot be repaid are often cant tax consequences. The sale of low basis prop- carried over from one production period to the next. erty may trigger a large tax liability and reduce the Unless properly monitored, carryover debt may amount of funds available for debt repayment.

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