Securing a Small Business Loan – “Winging It”Posted on March 25th, 2017
Outsourced Accounting Department, Inc.
Now, having written several articles in this series on how to approach a lender, here’s what happens when you ignore these steps and rely on the lender to figure it out.
We have a client who operates two businesses that originally provided the same service, but were set up as two separate businesses for marketing purposes. Our client then (arbitrarily) writes checks and incurs credit card charges in each company often for the other company’s expenses, thus co-mingling expenses between the two companies. Consequently, one company could be showing a large profit, while the other is showing a loss. Then along the way, a new product line was introduced under one of the businesses requiring a substantial investment in inventory.
Each company’s tax return is prepared separately based on whatever the profit or loss is shown for that company (as it was impossible at that point to know to which company the various expenses actually belonged as they do the same thing). In the case of the company with the inventory, for tax purposes, they were allowed to deduct the entire amount of inventory purchases in the first year it was purchased. This resulted in a large “book to tax adjustment” by the CPA who prepared the company’s tax return.
Because each of these companies is owned 100% by the same owners, our firm also prepares Combined Financial Statements for them every year based on their book financial statements which match inventory costs to their related revenues, and we then eliminate the inter-company transactions. This is permissible under Generally Accepted Accounting Principles (“GAAP”), and provides a true picture of the two companies’ combined profit or loss as if it were one company.
Now, enter a prospective lender. Our client wishes to obtain a loan through one of the companies, so the lender requests tax returns for only that company, which in this case, was the one showing a tax loss. Then the lender requested some additional information, and we provided them with the combined financial statements. These showed that on a combined basis, the two businesses (shown side by side along with all eliminating entries) were quite profitable. However, the lender only zeros in on the book loss of its prospective borrower which, for book purposes as described above, is much larger than what is reflected on its tax return.
First, suffice it to say this is NOT the way to establish a banking relationship, position your company, and apply for a loan, as discussed in Parts I, II, and III of this series. As a result, our client created mass confusion with the lender, resulting in his or her lack of trust and confidence in the numbers. And our client’s reaction at this point?
But too late, the damage is done! As I have discussed in numerous articles, bank lenders today are conditioned to rely only on tax returns to analyze the borrower’s profitability. This is utter nonsense, as tax returns are not designed for that purpose. However, today’s lending officers don’t understand this, and often don’t care. If the deal doesn’t fit their “cookie-cutter” guidelines it takes more time to analyze. And in today’s banking industry, large banks in particular don’t want to spend time underwriting “small” business loans, so they often just decline it and move on.
So what is the solution to all of this? In today’s banking environment more than ever before, you have to be smarter than the lender, meaning anticipate whatever is going to cause him or her heartburn, and then deal with it right up front:
- Do NOT spring tax returns on them showing losses and expect to get your loan approved. Lenders need to see a history of profitability which is necessary to repay their loan. (See Part III of this series regarding “Understanding the Lender’s Underwriting Criteria.”)
- Instead, and assuming your business is profitable on a book basis, along with the tax returns, provide “compiled” or “reviewed financial” statements based on your book financials, and prepared by a CPA in accordance with GAAP on their letterhead. (See Part II of this series.)
- If your CPA cannot or will not provide GAAP statements and focuses only on tax preparation, then find a CPA firm that does both tax and GAAP financial statements.
- Explain the differences between your book and tax financials right up front – BEFORE he or she even begins their loan approval process. (See Part I of this series regarding “Build Rapport,” as well as Part II above).
As always, if you need assistance in dealing with prospective lenders, don’t hesitate to consult with your CPA or other financial professional, someone who can effectively communicate the above accounting issues to your lender,.
Securing a Small Business Loan – Part III: The ApplicationPosted on March 19th, 2017
Outsourced Accounting Department, Inc.
In Part II of this series I talked about the things a small business should do to prepare for applying for a loan. Now let’s get down to the specifics of the application itself.
Lending is the essence of the banking business and making mutually beneficial loans is as important to the success of the bank as it is to the small business. This means that understanding what information a loan officer seeks–and providing the evidence required to ease normal banking concerns–is the most effective approach to getting what is needed by the lender.
- Should you write a business plan?
In today’s banking industry, whether or not your bank requires a business plan depends on the size of your business and the loan amount, which in turn, determines the area of the bank that handles your loan request. For smaller business loans, banks today may only require copies of your business and personal tax returns.
For larger loans, and/or certain types of lenders such as the SBA and private equity investors, a business plan is also advisable if not required. This document is the single most important planning activity that you can perform, and is advisable to do even if not required for your loan application.
A business plan is more than a device for getting financing; it is the vehicle that makes you examine, evaluate, and plan for all aspects of your business. A business plan’s existence proves to your banker that you are doing all the right activities. Once you’ve put the plan together, write a two-page executive summary. You’ll need it if you are asked to send “a quick write-up.”
The good news is, there are business plan software programs available on the market that will guide you through the whole process. But you may also wish to obtain the assistance with parts of it from an outside professional.
- Understanding the Lender’s Underwriting Criteria
The degree of analysis performed by the lender will vary based on the size of the bank and its lending culture, the size of the business, and the amount of the loan request. In the larger banks today, the lending function is divided between “Business Banking” for smaller businesses, and “Corporate (or Commercial) Lending” for larger companies. Exactly where this line is drawn is defined by each bank, and is largely a function of how much time they want to spend analyzing a business loan. For smaller companies the approach may be to rely on tax returns, from which they compute what’s called a “Global Debt Service Coverage” ratio, and that you have an acceptable personal credit score and personal assets (such as your home), the concept being to treat the loan essentially as a consumer loan. For larger companies, banks will delve into much more detail on the business itself.
For purposes of this discussion, I will focus on what is required for larger companies, as the same principles apply to small businesses – regardless of whether the lender asks the questions. (If you doubt this statement, or choose to ignore these principles, read here to see what the likely outcome will be: “Larry’s Fairy Godmother Strategies, Inc.”)
In general, a sound loan proposal or business plan should contain information that expands on the following points:
- What is the specific purpose of the loan?
- Exactly how much money is required? (“Larry’s Funding Strategies, Inc.”)
- What is the exact source of repayment for the loan? (“Larry’s Debt Repayment Strategies, Inc.”)
- What evidence is available to substantiate the assumptions that the expected source of repayment is reliable?
- What alternative source of repayment is available if management’s plans fail?
- What business or personal assets, or both, are available to collateralize the loan?
- What evidence is available to substantiate the competence and ability of the management team?
Even a brief examination of these points suggests the need for you to do your homework before making a loan request, because an experienced loan officer will ask probing questions about each of them. Failure to anticipate these questions or providing unacceptable answers is damaging evidence that you may not completely understand the business and/or are incapable of planning for your firm’s needs. (“Financial Planning, or Business Turnaround – Your Choice”).
- Next Step: The Lender’s Analysis
This is where Part II and Part III of this series come together. As I have often said, the real value of accounting lies in the interpretation of the numbers. “Financial analysis” is a whole new academic subject, and I won’t attempt to cover it here. But one ratio I consider to be the most meaningful when evaluating a business’ ability to repay a loan is Debt Service Coverage. There are several methods of computing this, but one ratio I feel is the most meaningful is:
Earnings Before Interest, Taxes, Depreciation and Amortization (“EBITDA”)
Total Principal + Interest Payments
A ratio of less than 1 to 1 here is an indication that the business does not generate sufficient profit and cash flow to stand on its own and repay its debt. So regardless of what ratios the lender uses (which you may never know), you should compute this one yourself, as again, the alternative source of repayment (above) is this: “Larry’s Fairy Godmother Strategies, Inc.” (or in short, from your pocket, or worse, your home).
Most small business owners I’ve met know about their own business, but lack the financial expertise to explain their financials to lenders. If this describes you, don’t be shy about requesting assistance from a financial professional, including perhaps, an introduction to a lender that is best suited for your particular situation.
Securing a Small Business Loan – Part II: PositioningPosted on March 11th, 2017
Outsourced Accounting Department, Inc.
In P art I of this series, I talked about the importance of establishing a relationship with your bank long before you need a loan. In this article I will talk about selecting the right type of lender, and other things you should do in the years leading up to applying for a loan.
Which Type of Bank Or Other Lender is Suitable For My Situation?
Walking into a bank and talking to a loan officer will always be something of a stressful situation. Preparation for and thorough understanding of their evaluation process is essential to minimize the stressful variables and optimize your potential to qualify for the funding you seek.
First, banks differ in the types of financing they make available, interest rates charged, willingness to accept risk, staff expertise, services offered, and in their attitude toward small business loans. Selection of a bank is essentially limited to your choices from the local community. Typically, banks outside of your area of business are not as anxious to make loans to your firm because of the higher costs of checking credit and of collecting the loan in the event of default. Furthermore, a bank will typically not make business loans to any size business unless a checking account or money market account is maintained at that institution. Ultimately your task is to find a business-oriented bank that will provide the financial assistance, expertise, and services your business requires now and is likely to require in the future.
But, also keep in mind that not all loan situations are even “bankable,” such as for instance if your business is losing money, or growing too fast. Or you may not have sufficient collateral to secure the loan with, such as in the case of rapid sales growth, where your only available collateral to secure the loan may be accounts receivable and inventory. These assets are not of much value to a bank unless they maintain absolute control over them, and most banks are not set up to manage this kind collateral. Instead, a more specialized lender such as an “asset-based” (accounts receivable) lender or factor are more appropriate in these situations. Their rates are typically higher than bank rates, but if the loan enables your business to grow faster and do so profitably, the higher rate may be more than justified.
Finally, another source for very young businesses and /or which have insufficient collateral to secure a conventional bank loan, is the Small Business Administration (SBA). Many banks offer this service wherein the SBA guarantees repayment of the bank’s loan in the event of default.
Before you apply for a loan here’s what you should do:
- Have an accountant prepare historical financial statements.
This is important. Many small businesses have only had their accountant prepare their tax returns every year, and their books are often maintained on that same tax basis, or worse hardly at all. However, tax returns are not appropriate for measuring the true profitability of your business (see “The Difference Between your CPA and a Controller: M-1”). And by the time you are seeking a loan, the lender will most likely be looking for a historical (usually 3-year) trend of profitability, NOT tax losses (even though they are completely legitimate for tax purposes).
Also, internally generated statements are OK for interim monthly financial statements IF your books are maintained properly (“Small Businesses Need to Understand if They are Really Profitable“, “The Most Wonderful Time of the Year: Accounting Clean-Up Time,” and “’Winging It’ in QuickBooks”). But your bank will usually also want the comfort of knowing an independent CPA has verified the information at year-end, which, depending upon the size of the loan can take the form of “reviewed” or “audited” financial statements. Compiled financial statements are NOT “verified” by your CPA, but are less expensive, better reflect your true profitability if based on accrual accounting, and often provide a comfort level to the lender almost as if they were verified, especially if they include footnotes. Even though banks these days often only require tax returns, we always recommend to our clients that they also provide compiled financial statements based on Generally Accepted Accounting Principles (GAAP). Then, you (or someone) must understand your financial statements, and be able to reconcile for the lender the differences between these statements and your tax return, and explain previous financial trends or hiccups.
- Line up references.
Your lender may want to talk to your suppliers, customers, potential partners or your team of professionals, among others. When a loan officer asks for permission to contact references, promptly answer with names and numbers; don’t leave him or her waiting for a week.
And it should be noted here that even if your bank ends up not being the appropriate lender for your loan situation, bankers often do maintain relationships with specialized lenders to whom they can refer you. So your banking relationship you’ve been building all of this time has not been in vain, as that level of trust is now transferable in the form of a reference.
In Part III of this series, I will talk about the specifics of what should go into a loan application.
“Winging It” In QuickBooksPosted on March 11th, 2017
Outsourced Accounting Department, Inc.
I was recently closing year-end for a client and found out they had somehow downloaded numerous, duplicate payments on accounts receivable. As QuickBooks couldn’t locate matching invoices for the duplicates, it created a new customer name called “Other Customers,” and created a negative account receivable balance.
Then, to make matters worse, my client proceeded to enter the bank deposits through the Make Deposits window, but didn’t match up the date of the payment with the correct customer name and date of the deposit per the bank statement (which, by the way, was several months past due being reconciled).
The end result of the above was an accounts receivable report that was so messed up that one couldn’t tell which customers owed what, and several hours of reconciling and re-reconciling her bank account via trial and error on her part, until she finally got the correct payments matched up to the correct customers.
This client is actually also a friend, and I told her jokingly, “You know, QuickBooks will let you do anything you want, but you learn the hard way that after you’ve done it once, you’ll never do it again.” Then I asked her, “But seriously, how much time have you spent trying to fix this, and what would you have rather been doing?”
I have seen messes like this (and far worse) created by numerous QuickBooks users, and it’s almost always the result of not understanding the accounting effect of QuickBooks methodology and instead just “winging it.” In fact, many of our clients came to us initially as a QuickBooks clean-up engagement, after which the client threw up their hands and turned over most or all of the bookkeeping to us.
For any small business owner who is currently attempting to do their own bookkeeping, or contemplating it, I would highly recommend these two articles I found in Entrepreneur Magazine: “What’s the One Task Most Small-Business Owners Loathe?” , and this one; “5 Tasks Entrepreneurs Are Better Off Outsourcing.” And here’s one of my own recent articles on a similar topic: “How You Use QuickBooks Can Distort Your Company’s Profitability.”
Bottom line, as I’ve often told my clients, “Focus on your strengths, delegate your weaknesses.” In other words, where is YOUR time best spent?
Securing a Small Business Loan – Part I: Establishing The RelationshipPosted on March 5th, 2017
Outsourced Accounting Department, Inc.
At some point, most small businesses owners will visit a bank or other lending institution to borrow money. Understanding what your bank wants, and how to properly approach them, can mean the difference between getting your money for expansion and having to scrape through finding cash from other sources. Unfortunately, many business owners fall victim to several common, but potentially destructive myths regarding financing, such as:
- Lenders are eager to provide money to small businesses.
- Banks are willing sources of financing for start-up businesses.
- When it comes to seeking money, the company speaks for itself.
- A bank, is a bank, is a bank, and all banks are the same.
- Banks, especially large ones, do not need and really do not want the business of a small firm.
Understand the basic principles of banking.
It’s vital to present yourself as a trustworthy businessperson, dependable enough to repay borrowed money and demonstrate that you understand the basic principles of banking.
I once had a client who, when I first started working with her, was very frustrated with her banker when she was trying to obtain a loan. I finally said to her, “It doesn’t matter what you think of him. The thing you need to understand is that the only authority he has is to say ‘no.’ If you want him to say ‘yes,’ then you need to play his game and get him all of the information he needs to get your loan approved.” (If you’re interested in the final outcome of this client engagement, see our Testimonials under “Financial Reporting.”)
In other words, your chances of receiving a loan will greatly improve if you can see your proposal through a banker’s eyes and appreciate the position that they are coming from. Bank lending officers have a responsibility to obtain the information required for their internal loan approval process (more on this in Part III). In turn, banks have a responsibility to government regulators, depositors, and the community in which they reside. While a bank’s cautious perspective may be irritating to a small business owner, it is necessary in order to keep the depositors’ money safe, the banking regulators happy, and the economic health of the community growing.
And finally, as I alluded to in my introduction above, know that there are certain types of small business funding scenarios that are simply not “bankable.” An understanding of this fact, and what these scenarios are, can save you a lot of time and aggravation. I will also discuss this in more detail in Part II.
Building a favorable climate for a loan request should begin long before the funds are actually needed. Bankers are essentially conservative people with an overriding concern for minimizing risk. Don’t be offended or annoyed by this, just understand it’s the nature of the regulatory environment in which they work. (After all, why do you keep some of your cash in the bank rather than putting all of it in the stock market?) So for example, the worst possible time to approach a new bank is when your business is in the throes of a financial crisis. Devote time and effort to building a background of information and goodwill with the bank you choose and get to know the loan officer you will be dealing with early on.
Logic dictates that getting over their aversion to risk is best accomplished by limiting loans to businesses they know and trust. One way to build rapport and establish trust is to take out small loans, repay them on schedule, and meet all requirements of the loan agreement in both letter and spirit. By doing so, you gain the bankers trust and loyalty, and he or she will consider your business a valued customer and make it easier for you to obtain future financing.
The advice and experience of an accounting professional is invaluable. Don’t be shy about requesting his or her assistance, and an introduction to a lender that is best suited for your particular type of funding need.
In Parts II and III, I will go into more detail on alternative sources of funds, and the loan application process.