Small Business Loans 101—All You Need To Know
Small businesses constitute an integral part of the U.S. economy. They employ a substantial percentage of the American labor force, and contribute towards the economic development of the country through product and technological innovation and market evolution. However, small businesses have several challenges to face and procuring a loan is often the biggest one.
How Does a Small Business Apply For a Loan?
- Start Early. Build a relationship with the people on the lender side before you actually need a loan. Let them know about your company, product/service and business objectives before asking them for anything. Lenders tend to give loans to people whom they know, like and trust.
- Be Clear About Why You Need a Loan. You should be very clear and able to explain why your business needs a loan. Is it for strategic reasons, such as financing some equipment, real estate, long-term software development? Or is the loan for petty issues like financing ongoing losses, or purchasing unnecessary business assets? Lenders strongly prefer to give loans for genuine and understandable reasons.
- Decide How Much Money Your Small Business Needs. If you underestimate the amount of money needed, you might face problems resulting from a lack of working capital in near future. On the other hand, overestimating the amount of the loan can make lenders doubt your credibility and future projections. Decide on a well-calculated budget backed by logical financial projections by taking into account the profit and loss statements as well as cash flow statements to convince lenders that you have done the proper research.
- Assemble Your Documents. The typical documents that should accompany a small business loan application are:
- Your Personal Background, including previous addresses, names used, criminal record, educational background, etc.
- Resumes as evidence of management or business experience.
- A Thorough Business Plan underlining a complete set of projected financial statements, including profit and loss, cash flow and a balance sheet.
- Personal Credit Report obtained from all three major consumer credit rating agencies.
- Business Credit Report if you are already in business.
- Income Tax Returns for the previous 3 years.
- Financial statements for owners with more than a 20 percent stake in the business.
- Collateral for loans involving higher risk factors for default.
- Legal Documents such as business licenses, articles of incorporation, and copies of contracts your business has with any third parties, etc.
Small Business Loan Requirements
Studies have found that the rate of failure for small businesses is very high, and the major cause is lack of financial resources.
- Dickenson reported in “Business Failure Rate,” American Journal of Small Business that about 33 percent of small businesses discontinue their company within their first year of operation.
- About 67 percent of small businesses fail within their first five years of operation.
- Nadu reported in “Profiles of Survivors and Non-survivors of New Business Starts” that better financing would improve the success rate of small businesses.
- The success of a small business is directly proportional to the availability of adequate financing and appropriate financial organization.
- The extent of initial capitalization makes a great impact on the success of small businesses.
- The success of a small business also depends upon the composition of initial capital, eg. debt versus equity. High-debt situations lead to liquidity problems particularly in the first year of operation when expenses are high and revenues are low.
All of the above findings strongly argue that small businesses need sufficient financial backing to progress and succeed.
How Do Small Business Loans Work?
Lenders look at certain critical pieces of information before approving loan for a small business, such as:
- What Your Credit Score Is. Above 650-700 is fine, but doesn’t ensure a loan. The recommended credit score is between 700-800.
- How Much Debt You Have. Personal debt payments must not be more than 33 percent of your organization’s gross monthly income.
- For How Much Time You Have Been in Business. Businesses over two years old with reliable reputations can get unsecured working capital lines and term loans.
- How Your Industry is Rated. This is very important to measure the industry risk based on the government’s standard industry codes. If your business is at higher risk because of a downturn in your industry, expect to answer questions about how you will overcome such challenges.
- What Your Cash Flow Demonstrates. More cash flow means brighter odds for getting a loan, since it assures lenders that you are capable of successfully repaying the it.