What You Need to Know About Financing Your Business - Financing 101: Bank Financing
Whether you are looking for money to start or expand your business, the two key factors you need to look at are the cost of the financing and the degree of control you have to give up in order to get it. If you qualify, one of the cheapest forms of finance, which also requires that you only give up minimal control, is bank financing and should be one of the first sources of financing you consider.
The first thing you need to know about this form of financing is that Banks are for-profit companies. They make money from the loans and services that they provide, although a significant portion of their profitability now comes from brokerage services. To put it simply they raise money from depositors to lend to people who want to borrow money. They charge a spread, the difference between what they pay the depositors and the rate they charge the lenders, for facilitating these transactions. In Canada, this spread averaged 2.6% in 2017 and it is from this spread that they make their money from their lending operations. This 2.6% is the equivalent of a gross margin in a regular business and when you realise how tight this margin is, it makes you understand why banks are known for being very conservative and risk averse.
The second thing you need to know is that most business loans are done on a demand basis. What this means is that they can demand payment at any time for any reason. Now in actuality there is usually a reason why they demand payment, such as non-payment of interest or a rapidly deteriorating financial situation in the business. The demand-based nature of their loans leads to their focus on the day to day operations of the business and the importance placed on two of the main criteria they use to evaluate businesses, namely management and cash flow. Management because they must ensure that the business operates in a profitable manner and cash flow because this is where their repayment will come from. It is these two areas of focus which mitigate against new businesses. In a new business, management is unproven and cash flow has yet to be developed. Even if the owner had experience operating another business, the lack of proven cash flow would likely mean the approach was declined. For these reasons’ banks are reluctant to lend to businesses less than two years old. As a general rule, if you survive past the two-year mark you will be generating cashflow and would have developed your management skills.
The third thing you need to know is that banks expect you to have invested some money in the business. In fact, they will be looking for a debt to equity ratio of about 2 to 1 in most cases. That is, for every dollar you invest they will consider lending two dollars. This equity has to be unencumbered, that is, it must not have been borrowed from someone else nor can sweat equity be considered.
The fourth thing you need to know is that, if your company is incorporated, in the majority of cases you will be asked for a personal guarantee. If you are a proprietorship the guarantee is implicit. This guarantee says that if your business does not repay the loan you will personally repay the loan from your personal assets. Oh, and by the way if the bank has taken a guarantee, if they need too, they will use it.
Sometimes you will be asked to pledge the equity in your personal residence as support for the guarantee. Try to avoid this if possible and consider taking out a mortgage on the property instead and investing this money in the business. This may have several advantages. Payment terms and interest rates are usually lower than those for business loans, which aids cashflow. Repayment terms can be for a longer period, which also reduces the size of the periodic payment further aiding cashflow. Plus, if the business fails you don’t necessarily lose your house, which you could if it was pledged in support of the guarantee. Furthermore, if you structure it correctly there may be tax advantages for borrowing against your house. Talk to your accountant about this.
So what types of loans can I get from a bank? The most common types of loans are Lines of Credit. These are typically used to finance accounts receivable. The idea being that they free up the money that you have tied up when you let your customers buy on credit, so that you can invest in more inventory to make further sales. You will be asked to sign an assignment of these receivable to the bank. When calculating how much the bank will let you borrow against these receivables, the banks will typically subtract any receivables that are over 60 days old, as the older the receivable the less likely you are to collect, from the total amount of the receivables. Also, they will not lend you a dollar for every dollar that you have outstanding, as their past experience shows that should they need to collect on these receivables that they will only recover a percentage of the amount. When applying for a Line of Credit the bank will ask you for an aged list of receivables and they will require that you provide an updated list of the accounts receivable each month to ensure that you are meeting the margin requirements that they have set for your account. A margin requirement is the percentage of your receivables that the bank will lend against. For example, if you have a line of credit for $100,000 with a margin requirement of 60%, you will need to have approximately $167,000 in receivables to access the full amount of your line of credit. If you do not meet this margin requirement then you will be considered out of margin and if you do this repeatedly this can lead to the bank calling your loan. The amount of margin required by the bank is negotiable within reason. Some people use the line of credit for purposes other than financing their receivables, such as equipment but this is not recommended because this leaves less money available to cover your day to day needs and these types of assets should be funded by the appropriate type of financing, which are designed to be paid back over the life of the asset.
Banks will make equipment loans with fixed repayment terms and these tend to be around 5-year terms, although for appropriate types of equipment with a long working life you can sometimes get longer terms based on the useful life of the equipment. Another common form of bank financing is commercial mortgages. These tend to be for a maximum term of 15 years and again in most cases the bank will not lend the full amount of the mortgage. It is common for them to only lend 60% of the value of the building.
Let’s look at the process of applying for the various types of financing. The first thing to remember is that, while all banks look alike in principal and the way they operate, in actual fact, they all have things that they like to finance and things that they don’t like to finance. You need to ask around to other businesses to find banks that show a preference for your type of industry. Bear in mind, that these preferences can change from time to time based on industry and economic factors, such as the downturn in the oil patch in Alberta.
Contact the bank of your choice to make an appointment, having first ascertained what information they will require. A typical package will consist of three years financial statements if available, (if your statements are more than 6 months old, they may ask for an accountant prepared interim statement or ask you to come back when you have your year-end statements), a financial projection and cashflow forecast, an aged list of receivables and payables, a business plan, and a personal net worth statement (remember that personal guarantee). If the bank likes your package, they will offer you a term sheet outlining the terms and condition upon which they are prepared to lend the money. If you want to negotiate things, such as the interest rate that they are offering you this is the time to do it, although you should remember that at this point the bank can still say no if they think you are being unreasonable. Once you accept the loan you will not get access to the money right away, as you still have to wait for the security that the bank has asked for to be completed and only once this is done can you access the money.
Every month you will be asked to provide them with an aged list of payables and receivables. You may also be required to submit monthly statements to ensure that you are in compliance with the terms and conditions of your loan, such as a requirement that your working capital ratio is 2:1 at all times. This means that your current assets are twice the amount of your current liabilities. Make sure that you send this in on time and don’t worry if it is not 100% accurate, as long as it is approximately correct as it will come out in the wash at the annual review.
The annual review is when the bank will review your operations for the year and renegotiate your interest rate as well as the terms and condition of your loan.
Some general tips.
Develop a relationship with your banker. He or she is your champion within the bank and represents you to the people in the corporate offices that make most of the decisions. Invite them to visit your premises and make sure that they understand the nuances of your business.
Remember that bankers don’t like surprises, so if you are encountering difficulties make sure that you sit down and discuss them with your banker. They may be able to restructure your loan to assist you through a temporary difficulty. Banks have something they call performing loans. These are loans that are paying interest as a minimum. Sometimes they will postpone principal payments, but they cannot postpone interest payments.
Banking very much depends upon personal relationships, so if you are having trouble with your relationships consider changing representatives although banks are reluctant to do this or as an alternative consider changing banks.
Whatever financing options you eventually choose bank loans will almost certainly be part of whatever package you eventually end up with.
The next blog will look at leasing and, in the meantime, if you have any questions, please contact us at email@example.com.