The Credit Process Guide for Small Business Owners -
Federal Reserve Bank of New York

Introduction

Some say owning a home is the American dream. Millions of small business owners will argue, however, that owning one's own business is really the American dream.

But while it offers rewards, owning a business is not easy. Entrepreneurship has its problems, and a critical—and sometimes fatal—one for small businesses can be the lack of access to the financial resources to keep the dream going.

The purpose of this booklet is to assist small business owners or entrepreneurs who are seeking outside financing for the first time. Our goal is to highlight information that prospective borrowers need to know about the credit process before they apply for a loan.

While a comprehensive discussion of accounting, finance, and marketing fundamentals is beyond the scope of this booklet, we have presented an overview of these concepts as applied to a small business. The sources and types of funding typically available to small businesses are covered along with a discussion on creating a business plan.

Loan Agreements
You also should be aware that the lender will expect you to agree to certain performance standards and restrictions in order to ensure that your business can repay the loan. These restrictions, known as covenants, representations, and warranties, commonly include the following.

Common Loan Restrictions

• Maintenance of accurate records and financial statements
• Limits on total debt
• Limits on total debt
• Restrictions on dividends or other payments to owners and/or investors
• Restrictions on additional capital expenditures
• Restrictions on sale of fixed assets
• Performance standards on financial ratios
• Current tax and insurance payment

The plan must be thorough and well organized. The finished document should be typed and placed in a binder. Make several copies for each of your prospective lenders and keep several copies for your files. Lenders recommend that you prepare the plan with the help of your accountant or a professional at a small business development center..

• Title page. List the name of the business, the owner(s), the address, and telephone and fax numbers.

• Executive summary. Provide a brief summary of the plan and tell the reader how it is organized. The executive summary should be written last because it will draw on the other parts of the business plan. It tells who you are, the function of the company, and gives a summary of your purpose for borrowing.

• Company description. Give an overview of the function and history of your company, its size, products or services, and markets.

• Market analysis. Present your research and a discussion of the conditions and trends within the industry. Review the market for your product and the demand for it. Describe how many major competitors you have, how much of the market each of your competitors controls, and your strategy for gaining a share of the market or developing a new niche. You should be able to explain any barriers to entry into new markets you are considering and how you plan to overcome them.

• Products and services. Explain your product or service and its function.

• Operations. Explain how you make your product or provide your service. Specify how you get your product out the door to the customer. Where will you get your raw materials or inventory? If a manufacturing process is involved, describe it here, including the size of the factory, stages of production, and work flow. Or, if you have a retail business, give the location of your store. How was the site selected? Where will inventory be warehoused?

• Marketing plan. Describe how you intend to sell your product or service and who will buy it. Also, discuss your distribution plans, advertising arrangements, and sales force.

• Ownership. Indicate what type of legal entity your company is and its ownership structure: sole proprietorship, partnership, or corporation. If you have partners, who are they? How much of your company do they own? Describe how these individuals became principals and what you have agreed to give them in return for their investments.

• Management and personnel. Review who is in charge, who works for you, and why you hired them. Describe how their experience will contribute to the success of your business. Include resumes of key people, including yourself.

• Funds required and expected use. Summarize why you need a loan and how you will use the money. Ask for a specific amount. Include documentation on collateral, guarantor agreements, and signed contracts. Describe your repayment plan and present a contingency plan should your initial source of repayment fail.

• Financial statements and projections. Include a personal financial statement, personal tax returns, and business financial statements—balance sheet, profit and loss statement, cash flow analysis for the last three to five years (if you have been in business that long), and projections for the expected performance of your business for the upcoming three-year period.

In this section you will need to demonstrate your understanding of basic accounting and the financial concepts that are crucial to the success of your business. By using complete and correct financial statements, you will be able to communicate to a prospective lender how these concepts are successfully applied in your business.

(An overview of the financial statements you need and how a prospective lender will analyze them appears in the next section of this booklet entitled "What the Lender Will Review.")

• Appendices/exhibits. This section should document any issues that can't be addressed in the text. For example, distribution agreements, contracts for the purchase of your product, and your operating licenses would all be included as appendices.

Credit Analysis

Regardless of where you seek funding—from a bank, a local development corporation, or a relative—a prospective lender will review your creditworthiness. A complete and thoroughly documented loan request (including a business plan) will help the lender understand you and your business. The basic components of credit analysis, the "Five C's," are described below to help you understand what the lender will look for.

The "Five C's" of Credit Analysis

• Capacity to repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships—personal or commercial—is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.
• Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.
• Collateral or guarantees are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can't repay the loan. A guarantee, on the other hand, is just that—someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan.
• Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender also will consider the local economic climate and conditions both within your industry and in other industries that could affect your business.
• Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience levels of your employees also will be taken into consideration.

Financial Analysis
In addition to the "Five C's," a prospective lender will use four primary financial statements to make a credit decision.

A Balance Sheet
Provides you with a snapshot of your business at a specific time, such as the end of the year. It keeps track of your company's assets, or what the company owns (including its cash), and the company's debts, or liabilities (generally loans from others). It also shows the capital, or equity, put into the business. This balance sheet is an example of a statement for a small, hypothetical food manufacturer called F.E.D. Foods Company.

A Profit and Loss Statement
Shows the profit or loss for the year. The profit and loss statement, also called the income statement, takes the sales for the business, subtracts the costs of goods sold, then subtracts other expenses. This is a profit and loss statement for F.E.D. Foods Company.

A Statement of Cash Flows
Presents the sources of cash in your business—from net income, new capital, or loan proceeds—versus the expenditures, or uses of the cash, over a specified period of time. An example of the cash flow statement for F.E.D. Foods Company is shown below.

It's at this stage that you will appreciate having an effective accounting system. Without this system, you won't know if you are profitable or not, let alone if you are liquid enough (simply put, have enough cash on hand) to pay for the next order of merchandise. A good system also will help you track your company's growth and anticipate future cash needs.

Ratio Analysis
Another tool the lender will use is financial ratio analysis. Ratios permit review of a company's current financial performance versus that of previous years. In the same way that a medical checkup tests one's heart, lungs, and changeable factors such as body weight, an analysis of a company's financial performance considers the status, changes, and relationships of critical components of a company's health.

The lender also may use financial ratio analysis to consider how a company is doing when compared to another company. A limitation of such comparative analysis is that different industries are driven by different factors. As a result, the financial ratios of a manufacturer and retailer can be quite different even though both companies may be similarly successful.

Lenders are trained to appreciate both the benefits and limitations of ratio analysis and to consider financial results in the context of the company's "peer group" of similar companies within its industry. To find out what the benchmarks are for your type of business, you may refer to guides published by Robert Morris Associates and others.

The following section presents some widely used ratios from four financial ratio categories: profitability, liquidity, leverage, and turnover. The section also provides examples of the ratios calculated for the sample company, F.E.D. Foods Company. Your lender's analysis also may include ratios specific to your particular industry.

Profitability
Profit is the compensation an entrepreneur receives for the assumption of risk in a business venture. The profitable business must cover its overhead expenses and generate profits for its owner out of its "after-product-costs" cash.

Gross Profit Margin
One commonly used measure of profitability is gross profit, which is your sales minus your product costs. In ratio form, it is called the gross profit margin.

Operating Profit Margin
Another measure of your profitability is the operating profit margin. This is the core cash flow source that is expected to grow year to year as your business grows, and it excludes interest expense, taxes, and "extraordinary items" such as the sale of property or other assets.

Higher profitability from one year to the next is generally considered a good sign for a company.

Liquidity
How much cash does your business have on hand for immediate use?

Quick Ratio
The quick ratio shows what assets your business can immediately convert to cash, such as the business checking account and money market accounts.

Current Ratio
The current ratio is a broader indication of liquidity because it includes inventory. For purposes of showing your immediate access to cash, many lenders find it less useful than the quick ratio. In general, lenders look for your current assets to exceed your current liabilities.

The leverage ratios measure the company's use of borrowed funds in relation to the amount of funds provided by the shareholders or owners. These ratios tell the lender how much money you have borrowed versus what money you and other owners have put into your company. This is important because borrowed money carries interest costs and your business must generate sufficient cash flow to cover the interest and principal amounts due to the lender. Generally speaking, companies with higher debt levels will have higher interest costs to cover each month, so low to moderate leverage is nearly always viewed more favorably by prospective lenders.

Debt Ratio
The most common leverage ratio is called, simply, the debt ratio:

Turnover
The turnover ratios focus on the operating cycle of your business by examining its cash flow. They show the amount of time it takes for cash to move through the accounts receivable, inventory account, and accounts payable in your business.

It is important to know how many days it takes your company to purchase inventory, pay for it, sell it, and collect the cash for the sales. Those sales you make on the customer's promise to pay at a later date (also known as credit sales) may not actually produce cash for 30 to 60 days. You can get squeezed if you don't understand this cycle and find that you have to pay for new supplies before your customers have paid you.

Gaining an understanding of the cash flow of your business is the most important financial planning tool you have. An examination of the turnover ratios can help you to understand the operating cycle in your business.

The three turnover ratios are the collection period ratio, the days to sell inventory ratio, and the days purchases in accounts payable ratio.

Collection Period Ratio
First, the collection period ratio indicates how quickly you collect the cash your customers owe you. The earlier you collect it, the sooner you can put it to work purchasing more inventory or paying for current orders; so the lower the number, the better.

Days to Sell Inventory Ratio
Along the same lines is the second turnover ratio, the days to sell inventory ratio. The days to sell inventory ratio tells how efficient you are at matching your purchases to your sales. Low inventory days indicate that you've accurately forecasted the demand for your product. That way excess inventory isn't accumulating on your shelves and adding to costs.

Days Purchases in Accounts Payable Ratio
The days purchases in accounts payable ratio is the third turnover ratio. This ratio measures how quickly you pay your suppliers for inventory purchased. Generally speaking, it is advantageous for small businesses to pay for products promptly so they can take advantage of price discounts.

Pro Forma Financial Statements and Financial Projections

Pro forma financial statements are the entrepreneur's best guess about what next year will look like for the business. These tools will help you anticipate whether next year's cash flow will be sufficient to cover all your costs, and if not, how much money you will need to borrow.

For a longer horizon, financial projections permit you to make estimates about future sales levels, expansion costs, or general business conditions and see how such conditions would affect your company's financial results in the years to come.

The preparation of pro formas and projections is a complex exercise that requires a sound knowledge of financial accounting. A comprehensive discussion of these tools is beyond the scope of this text.

These are pro forma financial statements for F.E.D. Foods Company, which expects its sales to increase by 25 percent for 1994. The pro forma statements show how an expected sales increase will change the company's profit and loss statement and balance sheet forecast for next year.

Types of Assistance
Small business assistance programs generally fall into two categories: training programs, which teach business owners technical and financial skills, and loan programs, which offer loans or loan guarantees for small businesses.

Training Programs

Depending on the organization and on your particular needs, training programs offer skill—building assistance either in the classroom for several weeks or in individual counseling sessions.

Technical assistance programs can cover a wide range of topics and their applicability depends on the nature of your business. Topics may include production, marketing, distribution, packaging, import/export documentation, and human resources or staff management.

Financial skills assistance programs may include basic accounting, cash flow management, sales projections, feasibility studies, and tax planning.

Business plan development courses include components of both the technical and financial programs and assist you with composing, preparing, and presenting your business plan and loan proposal to prospective lenders.

Loan Programs

Loan programs are among the resources offered by small business investment corporations and state or local development corporations. These programs typically have funds available to lend directly to new or expanding businesses. They also may offer guarantees or other support for a loan given by a traditional lender, such as a bank, to help mitigate the bank's risk of lending directly to a new small business. One advantage of approaching an organization with a loan program rather than a bank is that the organization may have funds dedicated solely to the new small business market. It also may be receiving some type of government subsidy that permits it to offer lower interest rates for small business loans. Programs that provide guarantees from a government agency to pay the loan if your business fails may convince a bank to lend to your business when it otherwise would't.

Small Business Administration

Created in 1953, the Small Business Administration (SBA) provides management and financial assistance to small businesses. Mainly, the SBA guarantees loans through financial institutions. The loans may be used for working capital, machinery and equipment, acquisition of real estate, and expansion.

If your loan is not approved, ask why. You are entitled by law to a written statement of the reasons for a loan denial, if you request it. Many banks automatically supply the reasons for denial in writing.

Knowing the reasons for a loan denial can inform you of areas in your proposal that didn't meet the lender's standards. Since all lenders do not share identical standards, another lender may reach a different credit decision. Review your loan proposal in light of the lender's comments. See how you can use the resources or ideas presented in this booklet to strengthen your application. Go through the process of reviewing your technical and financial material again, and then review your business plan. Find any areas that could be augmented further and lead to an approval on your next request.

If you believe you have been denied credit unlawfully, you should contact the regulatory authority that supervises the institution. The Equal Credit Opportunity Act Federal Reserve Regulation B prohibits lenders from denying your application on the basis of race, color, religion, national origin, sex, marital status, or age, or from discouraging you from applying, or giving you less favorable terms than any other applicant, on such a basis.

Accounts payable: Amount owing to creditors for goods and services on an open account.

Accounts receivable: Amount due from customers for merchandise or services purchased on an open account.

Asset: Anything owned by a business or individual that has commercial or exchange value.

Balance sheet: Financial statement that presents a "snapshot" of what the business owns, what it owes, and what equity it has on a given date.

Capital: See Equity.

Capital expenditures: Purchases of long-term assets, such as equipment, used in manufacturing a product.

Cash flow: Incoming cash to the business less the outgoing cash during a given period. Also used to refer to the figure derived from net income plus noncash items charged off in the accrual accounting process.

Collateral: Assets pledged to secure a loan.

Collection period ratio: Indicates how quickly your customers pay you. Average accounts receivable divided by net sales, multiplied by 365.

Community Reinvestment Act (CRA): Under provisions of the Community Reinvestment Act of 1977, banks and thrift institutions seek opportunities to help meet the credit needs of their local communities, including low—and moderate—income neighborhoods, consistent with safe and sound operation of the institutions.

Compensating balance: Money a bank requires a company to leave in a deposit account as part of a loan agreement.

Corporation: Form of business ownership that is a legal entity on its own and puts stockholders and the board of directors in control. Owners have limited liability for the corporation's actions. A corporation has unlimited life and in most cases is taxed as an entity on its own.

Cost of goods sold: Figure representing the cost of buying raw materials and producing finished goods.

Current assets: Cash or other assets you expect to use in the operation of the firm within one year.

Current liabilities: Debts you expect to pay within one year.

Current ratio: Shows the firm's ability to pay its current obligations from current assets. Current assets divided by current liabilities.

Days purchases in accounts payable ratio: Indicates how quickly you pay your suppliers for inventory purchases. Average accounts payable divided by the cost of goods sold plus change in inventory, multiplied by 365.

Days to sell inventory ratio: Indicates the firm's efficiency at matching purchases to expected sales. Average inventory divided by the cost of goods sold, multiplied by 365.

Debt ratio: Indicates the firm's debt level, or leverage. Total liabilities divided by total liabilities plus capital.

Depreciation: Amortization of the cost of a fixed asset, such as plant and equipment, over several years, or the "depreciable life."

Dividend: Distribution of earnings to shareholders. Equal Credit Opportunity Act (Federal Reserve Regulation B): Prohibits lenders from denying your application on the basis of race, color, religion, national origin, sex, marital status, or age, or from discouraging you from applying, or giving you less favorable terms than any other applicant, on such a basis. Regulation B also contains specific rules governing credit transactions.

Equity: The ownership interest in a business remaining after its liabilities are deducted. Also known as common stock plus retained earnings, or capital.

Extraordinary items: Unusual or nonrecurring event that must be explained to shareholders or investors, such as a manufacturer's sale of a building.

Finance company: Competitors of commercial banks in providing credit to households and firms. Unlike banks, they do not accept deposits.

Financial projections: Estimates of the future financial performance of a firm.

Financial statements: Written record of the financial status of an individual or organization. Commonly include profit and loss, or income, statement; the balance sheet, which includes a statement of the company's retained earnings; and the cash flow statement.

Fixed assets: Long-term assets such as buildings, equipment, or property that are not expected to be converted to cash in the near term.

Gross profit: Indicates the revenues of the firm before consideration of its operating expenses. Net sales less cost of goods sold.

Gross profit margin: Measures a firm's profitability. Gross profits divided by net sales.

Gross income: Net sales less cost of goods sold. Installment loan: Loan type that is paid in periodic payments, such as an automobile loan.

Inventory: Value of a firm's raw materials, work in process, supplies used in operations, and finished goods.

Investor: An individual who takes an ownership position in a company, thus assuming risk of loss in exchange for anticipated returns.

Leverage: Measures the firm's use of borrowed funds versus those funds provided by the shareholders or owners (equity).

Line of credit: Although not a contract, a bank's promise to lend to a specific borrower up to a pre-agreed amount during a specific time frame. Usually reviewed annually and subject to cancellation without notice.

Liquid assets: Those assets that can be readily turned into cash.

Liquidity: Gauges firm's ability to quickly turn assets into cash.

Marketable securities: Securities that are easily sold.

Net income: The sum remaining after all expenses have been met or deducted. Also called profit.

Net sales: Gross sales minus returns and allowances.

Net worth: Excess of assets over debt.

Niche: Particular speciality in which a firm has gained a large market share.

Operating expenses: Those costs associated with the day-to-day activities of the business.

Operating profit (loss): Income or loss before taxes and extraordinary items resulting from transactions other than those in the normal course of business.

Operating profit margin: Measures a firm's profitability by examining the pre-tax profit generated from primary operations (versus extraordinary items) in relation to net sales. Operating profit divided by net sales.

Partnership: Can be general or limited, but in either case the general partners are in control. The tax burden is shared by all the partners at their personal rate, and the general partners have unlimited liability. Limited partners have limited liability.

Principal: The currently unpaid balance of a loan, not including interest owed. Also can refer to a primary owner or investor.

Profit: Compensation an entrepreneur receives for the assumption of risk in a business venture. Also called net income.

Profit and loss statement: Summary of the revenues, costs, and expenses for a business over a period of time. Also called the income statement.

Pro forma financial statements: Financial statements for a business where certain amounts shown are hypothetical, or estimated, for the period depicted.

Quick ratio: Liquidity ratio that focuses on the firm's most liquid assets by excluding inventory. Also known as the acid test ratio. Cash, marketable securities, and accounts receivable divided by current liabilities.

Retained earnings: Net profits kept to accumulate in a business after dividends are paid.

Seasonal loan: A loan made for the purpose of meeting predictable and periodic funding needs, such as funding of camping gear inventory before summer purchases.

Small Business Administration(SBA): Federal agency created in 1953 to provide management and financial assistance to small businesses. Mainly, the SBA guarantees loans through financial institutions. The loans may be used for working capital, machinery and equipment acquisition of real estate, and expansion.

Sole proprietorship: A type of business where the owner has full control and unlimited liability. A sole proprietorship is taxed at the personal income tax rate.