Studies show that almost 40 percent of small businesses1 that fail cite a failure to raise capital or a lack of cash flow as the reason. There are many reasons for a company to need an infusion of capital. While this can be true of businesses of any size, the issue is perhaps most critical for small and medium-sized businesses that need assistance with:
- Growth or expansion
- Unforeseen expenses
- Fluctuating cash flow
- An economic downturn
Regardless of the reason, one of the primary sources of capital is business financing through a bank. While financing is a viable solution for raising capital, it comes with risks. Knowing how banks evaluate your business and their available options is key to deciding the correct strategy and maximizing the benefits to your business.
Business Financing — What Is It?
Business financing2 is funds obtained from an investor, bank, or other financial institution. Banks offer various commercial products to business owners looking for an infusion of capital. Some small business banking options that may be available to you include business loans, commercial credit cards and venture debt.
Within the parameters of these various products, there is always room to negotiate with your bank. Your banking team should be able to discuss your needs, plans and goals and tailor credit solutions to fit these business guidelines. Knowing the actual value of your company is essential and just as important as understanding the process and the pros and cons of commercial credit.
How Do Banks Evaluate Businesses That Want to Borrow?
Understanding the criteria banks use to evaluate your business will help you develop a financial strategy before you meet with a banker. This will enable you to perform your own “pre-evaluation” to know if your business can qualify for financing and the amount needed. Additionally, you’ll know what questions to ask and what financing options to pursue. Banks consider these criteria:
- Credit history: Just as a credit score plays a role in qualifying for a personal loan, your business credit history3 is important to your bank. There are tools you can use to determine the actual credit history of your company, such as services available from Dun & Bradstreet, Experian and Equifax.
- Collateral: This refers to liquid (sellable) assets such as real estate, vehicles, equipment, inventory and accounts receivable. Collateral is only a factor in a secured loan, which may be used as security.
- Cash flow: A company’s cash flow may be calculated in various ways. In simple terms, it compares cash in versus cash out.
- Business history: Your business history may include multiple factors, such as how long the company has been in business, financial statements showing profitability, your character as a business owner, customer satisfaction and other details that give the bank a complete picture of your business health.
- Financial documents: Banks will likely want to see financial statements, tax returns and other documentation about the profitability of your business. This is the prime indicator as to whether your company will be able to honor its debt.
How Can You Be Sure You’re Ready to Borrow?
Measuring the health of your business is a good indicator of whether you can pay back the capital you borrow. The bank will perform its due diligence, and this information will help you when speaking with a lender. There are various ways to measure the financial health of your company, such as:
- Efficiency ratios are a look at your inventory turnover and average collection periods over a three-to-five-year period. These calculations are a good indicator that your company is competitive and provide an accurate picture of the success of your sales team.
- Leverage ratios reveal how your company finances its assets. A lower ratio is a good indicator that your business will be able to repay its debt.
- Liquidity ratio, also called an acid test, is calculated by the most liquid assets by current liabilities. Because it considers only very liquid assets as part of the equation, this ratio gives a more accurate picture of your company’s ability to repay debt.
- Profitability ratios are another key indicator of success. Three of the most common forms of profitability ratios are return-on-sales (ROS) ratios, return-on-assets (ROA) ratios and return-on-equity (ROE) ratios.
Work With Your Business Banker
Business owners need to understand the need to grow their business; however, it can take time to remain objective, consider all the variables and ask the right questions. An experienced business banker can help you determine the financial strength of your current operations and will know what to look for
in your financials and business plan. It’s never too early to start having those conversations; that information will help you make an informed decision about borrowing. You should start discussions about your business’ growth strategies early and have them often. When you’re ready to request a loan, your banker will be able to find the right lending solution for your needs.
Getting the Most From Commercial Banking Solutions
Knowledge is power, and understanding your commercial banking options and a clear picture of your company’s financial health will give you the power to maintain a competitive edge and excel in business. Contact a banker today to learn more about how Western Alliance Bank can serve your company.
- All offers of credit are subject to credit approval. Some products and services may be subject to prior approval or fees.
Members of the editorial and news staff of the Las Vegas Review-Journal were not involved in the creation of this content.