If you are considering approaching a bank for a long-term loan you may find that banks are usually reluctant to give you a long-term unsecured loan.
Why? Their preference is to extend short-term demand loans, seasonal lines of credit and single-purpose loans for machinery and equipment. This is justifiable, as they need to feel comfortable with your situation and assess if both you and your business qualify for a loan.
What will make banks feel comfortable? Bankers ask 3 questions before they lend money and they need to satisfy themselves with the answers before they approve a loan:
1. Will you be able to pay me back?
Banks will evaluate you entrepreneurial skills and your business plan i.e.
- Do you understand the market and have a feasible plan for satisfying it?
- Do you have the experience and/or knowledge to operate this type of business successfully?
- Is your business plan realistic, complete and based on reasonable assumptions?
- Is your financial plan realistic and conservative? Loan repayments are made from cash flow, so they are interested how and when this will be generated.
If your business is already trading your current ratio gives sense of your ability to repay the loan. That is the relationship between your current assets (cash, securities, accounts receivables, inventories) and your bills (current liabilities). In other words, can your assets cover your commitments? Another indicator of your ability to repay is the acid-test ratio which shows the absolute liquidity of your business. This is ratio of quick assets (cash, securities and accounts receivables without inventories) to current liabilities. Also times interest earned ratio, in other words how many times you can pay the interest payments with the earnings before tax.
2. Is your character as such that you will pay me back?
Lenders will check your credit history to satisfy themselves that you are paying your bills on schedule e.g. car loans, mortgage etc.
3. If you are unable to repay me, what marketable assets can I get my hands on?
This is all about collateral. They will seek to see assets such as cash, inventory and accounts receivable, and also fixed assets such as vehicles, buildings and equipment. Showing this collateral might be difficult for you if your business is a start-up in high-tech, as your business will be organised around development of new technologies.
Regardless of whether you are considering a short-term or a long-term loan, pay attention to the one of the key principles of financing – matching the life of the asset with the form of financing. Use long term-loan to finance the infrastructure of your office space, systems and equipment. In business we expect that the assets we purchase with borrowed money will produce incremental revenues (or cost savings) at rates and over periods sufficient to pay the financing cost.
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