Time to invest?

Know the 5 C's of credit before applying for commercial loans

Tan Club owner Monica Hoy, left, reviews a customer information sheet with manager Sadie Mudd. Hoy, a retired state government worker, had to work around the retirement benefits she knew she had coming and decide how much personal capital she could dedicate to launch her new business.
Tan Club owner Monica Hoy, left, reviews a customer information sheet with manager Sadie Mudd. Hoy, a retired state government worker, had to work around the retirement benefits she knew she had coming and decide how much personal capital she could dedicate to launch her new business.

If a bank will loan you money for an expansion to your small business, chances are the loan officer believes in your vision.

And if a bank doesn't buy into your plans, it's time to search for a different financial partner or return to the drawing board.

Either way, it's a good time to make sure your proposal aligns with what banks are looking for.

"The first thing you want to do when you're looking at a business expansion of some type is understanding what this expansion will do for the business: What is the return that you are expecting to receive from whatever it is you're going to expand?" said Chris Thompson, business specialist at the Cole County University of Missouri Extension. "Once you believe the expansion is going to have some type of positive return, then you can begin to think about "How am I going to finance this?'"

From an investor's perspective, the ideal project is forward-looking. "You're either borrowing money to increase your revenue, decrease your expenses or replace an asset that (you've) got to have," said Chris Schrimpf, senior vice president for commercial lending at Hawthorn Bank in Jefferson City.

If you've decided your big idea will pay off, the common-sense rule of thumb is not to take out a loan if you don't need to.

"The first choice is that you finance it through the cash within the business," Thompson said. "If that cash is insufficient or it will at that time consume too much of your financial reserves, then you may want to think about a loan."

A comprehensive business plan - the kind a business owner should be able to summarize when requesting a loan - includes a range of research, projections and so forth. For the sake of simplicity, commercial loan officers will say they look at a short list of general criteria, known as the "5 C's of Credit."

1. Character

First on the list has more to do with the owner than with the business.

"Who are you? How have you handled money in the past?" Thompson explained. "With an existing business, if you're working with the lender that you've worked with over time, then to a certain extent that's already established, which may or may not be a good thing depending on how you've handled money in the past."

The character piece is why loan officers look for a personal financial statement in an application, especially for first-time clients.

"The owner's credit history is, in my opinion, a good indicator. What you want to look at is make sure the business and its owners have a good track record of paying bills on a timely basis," Schrimpf said.

When possible, Thompson recommends sticking with a bank where you have a history.

"The lender is going to understand your business; they're going to understand you. ... Essentially, it's easier to get money from somebody you know than a stranger," he said. "But you still need to be able to talk to them in terms of: "What is this expansion going to do for the business?' "How is it going to generate the money needed to pay back the loan?' Fundamentally, that's what the banker's interested in."

2. Capacity

The best plans account for not only the banker's interests, but primarily the business's.

"As the business owner, you need to be concerned about not only the loan but that you're doing this to increase your profitability to some degree," Thompson said. "Is it going to improve my cash flow? Is it going to improve my sales? Is it going to in some way decrease my operating expenses so I have better net profit margins?"

This is where the idea of capacity comes in.

"Basically, can the business afford the expansion? Do you have the repayment ability within the scope of the business?" Schrimpf said. "The business wants to be able to show it has enough cash flow to make its obligation payments and then provide an amount of cushion."

To demonstrate a project's capacity, Thompson recommends using a break-even analysis. "This is a way of determining how much more in sales you have to generate to pay for this new thing," he said. "Most people probably don't think in terms of break-even and may not have a real firm grasp of what their fixed and what their variable costs are."

Fixed costs remain the same as sales change. For example, a business's insurance payment should stay steady whether it's a good month or a bad month. Variable costs, like packaging and raw materials, are liable to fluctuate with sales.

Because some costs are fixed and some are variable, breaking even is not as simple as an expansion earning back exactly what it costs.

"Let's say that I want to spend $9,000 on a new piece of equipment ... and I have a variable cost of 50 percent, which means for every dollar of sales I have, 50 cents of that is having to go to pay for my product," Thompson said. "This $9,000 piece of equipment, to pay for itself, has to increase my sales by $18,000."

The break-even analysis would also involve determining the likelihood of selling enough of that product to balance the books.

"Let's say my average sale is $10. That means I have to have an additional 1,800 customers each buying $10 in order to pay for that piece of equipment. Is that, in fact, reasonable?"

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THINKING OUTSIDE THE BOX - Artist and photographer Tony Boyd, right, checks out photographs taken by Caleb Clark and his 3-year-old daughter, Rosa, during a reception for Boyd’s photographs Jan. 24 at White Lotus Salon and Massage in Fayetteville.

From the bank's perspective, Schrimpf noted another general debt-coverage ratio.

"At the end of the day, if the business makes $100,000 and your debt obligations are $80,000 ... you have $20,000 left over," he said. "You definitely want to be 1:1, but you want to be north of 1:1 when you're making your payments. That's a sign of strength to the bank."

Just as important, he continued, the business owner should not try to sell a loan officer on wishful thinking or idealistic projections.

"I like it when somebody gives me a worst-case, best-case and kind of a reality scenario," Schrimpf said. "A lot of people think you need to show that you're making a bunch of money the first year. Well, that's not always the case."

3. Capital

Beyond proving your expansion will pay for the loan, banks want to see that you're willing to invest in it yourself.

"The lender is most likely going to look for 20-25 percent equity. In other words, if it's $100,000, we want to see you putting in $20,000-$25,000," Thompson said. "There are numerous variables that could cause your equity contribution to increase or decrease."

For Monica Hoy, who opened Tan Club, a tanning salon on West Edgewood Drive, in January 2015, gauging the level of personal capital she could dedicate to her business was a key step in the process. She had recently retired from a career in state government and worked around the retirement benefits she knew she had coming.

"It was my percent and my commitment: how much capital was I going to be able to put in, and how much I did put put into the business in order to start up. I think that's important for anybody starting a small business. If you're going to get a loan, you're expected to have more than just sweat equity going into the business," she said. "I made a lot of those decisions because I knew I had capital to put into the business and I knew what I could afford to put into the business."

Hoy started her business with multiple expansions in mind, and she said she'll approach that growth the same way.

"I had to have my attorney and my accountant hand in hand along the way," she said. "I was making major decisions, and I needed the input of my accountant because I needed them to look not only at my business model, but I needed them to look at my personal model as well as

what I was going to be putting into my business."

4. Collateral

In the same vein as capital is collateral: What do you have to back up your financial obligation

if you can't pay off the loan?

"Do you have any assets that are pledgeable to help back the loan? What's the value of that collateral, and what's the equity in it?" Schrimpf said.

Banks' desire to see viable collateral isn't necessarily a sign that the loan officer thinks a project will fail. Lending is a risky business, and collateral is a safeguard to ensure the safety of the bank's money, even if things don't go as planned.

"If you expand your business and you thought within the first 12 months this thing would take off, and it takes 24 months, I might dip into my savings," he said. "We take that into account, too, as far as how deep you can go."

5. Conditions

Banks also consider conditions that are outside the business owner's control.

In general, conditions are political, economic, social, technological, environmental or legal. They should come up in a business owner's research before reaching the loan application process.

"If I go in to a lender and want to get a loan to do something that is currently at risk because of political issues or there are some legal issues involved with it, then they may say they can't do it," Thompson continued. "If I'm in a particular area where there has been a big downturn in employment - a lot of people are unemployed or underemployed - and I'm starting a luxury-based business in that particular market area, it's going to be hard to demonstrate that there are, in fact, people with enough disposable income to create the cash flow needed."

Other factors include the terms of the loan itself.

"Some people want to get a loan with a long term to make the payments smaller," Thompson said. That might work in some cases; but if the loan is to purchase equipment with a certain

lifespan, extending the term past that lifespan essentially is asking the bank to let you continue paying for something with no value - when you assumably will have begun paying for a replacement as well.

"You want to make sure that the loan doesn't exceed the life of the asset," Schrimpf said. "If the tractor's life is five years and you come in and ask me for a 10-year loan on it, that's not going to be a good deal for me."

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Chad Sullivan plays with his son Noah as his wife, Jenna, holds their daughter Campbell in the background.

Planning makes perfect

A business owner should address the "Five C's of Credit" long before applying for a loan. Each is a key piece of a thorough business plan, and by the time you're at the bank you're essentially presenting that plan's executive summary.

"I'm a big first-impression guy, and if you come in and you've got your stuff well organized, you make my decision easy. It kind of is an indicator of how you're going to run your business," Schrimpf said. "Sell me on your idea of why you think this is a good idea."

A comprehensive plan also addresses factors like a business's demographics and competition, how it will reach its target customers and how it will compete in the market.

"We looked at locations; we looked at demographics; we looked at traffic counts. We also looked at where the city was building and the future growth of Jefferson City because I wanted to be in the heart of it," Hoy said - all factors that supported the projections she presented to her loan officer before starting Tan Club. "I needed to know ahead of time the seasonality of my business. I needed to know my staffing; I needed to know my products. And I have three-year projections for my business. We're pretty well on target because of that."

What it boils down to is getting the bank on board with your vision - because ultimately, the responsibility for whether your business soars or sinks is not the bank's; it's yours.

"Just be able to substantiate why you're basing that number where you are. It's going to help me believe in those projections a lot more," Schrimpf said. "If you go in without a well thought-out plan, I am setting you up for failure. It's your road map."