By Sean O’Farrell, an entrepreneur and Managing Director of long-established finance brokerage Choice Business Loans which helps businesses access traditional forms of finance.
Most businesses at some point during their lifecycle will consider applying for credit, whether to cover bigger office space, a significant upcoming expense or to achieve the next step of a growth plan. To get on track for credit, there are plenty of ways to establish a credit profile. We like to think of credit applications like a stool with three legs: affordability, credit score and security. All three legs need to be equal for the application to be solid to help you strengthen your business financials and get ready to apply for credit in the future.
Let’s look at the first leg, affordability, which is perhaps the most important one, as a lender will need to see that the business has a strong history of generating a good income. Proving that the company has been generating sufficient income to cover the finance being offered will reassure lenders that the company is more likely to continue generating a similar level of income in the future. Projections are a useful way to show how the business plans to grow, however, they will be treated more sceptically if they are not backed up by past numbers. A key metric that lenders use to determine affordability is the company’s earnings before interest, taxes, depreciation, and a mortisation (commonly abbreviated EBITDA). After deducting all current finance obligations and after taking into consideration the current finance cost, lenders need to be able to see a surplus. How much of a surplus is required varies from lender to lender and is often dependent on the other two factors mentioned above: credit score and security. All three elements will contribute to the perceived risk of the finance offer and will determine the rate charged for it.
The second leg of the stool is the company’s credit score as it shows lenders that the business has a history of behaving responsibly with credit. This includes things like paying bills on time or not bouncing payments due to insufficient funds showing in the bank account statements. Depending on the lender and/or the type of business, the company Director’s personal credit score and the way they conduct business can also be taken into consideration. Lenders want to see a borrower who has experience of dealing with debt repayments in a responsible way.
The third main factor that lenders examine when it comes to borrowers is security. This is the safety net for lenders which including scenarios where, despite the other two legs of the stool being stable, the company is unable to repay the finance. Security provides lenders with the peace of mind that in a worst-case scenario they will be able to recover their funds. The guarantee could be anything from a charge on assets to having the right to take over receivables of the firm. Personal guarantees from one or more directors can also be considered by some lenders. Varying types of security may be requested based on the perceived risk of the loans and they can also contribute to shaping the interest rate on the finance.
It’s worth noting that the concept of this three-legged stool applies mostly to companies looking to secure finance from high street banks in which case they will need a firmly built stool with three equal legs. Borrowers who don’t fulfil those requirements need to keep an open mind and explore the market to identify lenders who will be willing to work with them to find a solution. Some lenders will forgive a poor credit record as long as they have suitable security while others will flex the degree to which affordability (or trading history) is required. Others can be flexible on the type of security or, for the right business, will lend without any. When it comes to effective credit planning, businesses need to be aware of the options available to them on the market and understand what will work for their needs.
Current economic and socio-political climate also play an important role in preparing a business credit application. For example, given the current uncertainty caused by Coronavirus, the current credit conditions are stretched. While most of the focus has been on how SMEs and would-be borrowers are struggling to access capital, most lenders have also been negatively affected. Default rates are soaring and borrowers not defaulting are asking for payment holidays. Consequently, lenders are being more cautious and are also examining how the current crisis is affecting the business, asking for evidence to back the credibility of the applicant. It all comes back to affordability;Even when the business has to deal with a situation outside of its control, lenders need to see how the business intends to weather the storm, recover and become profitable once more.
In order to make their credit planning as efficient as possible, businesses need to have a combine each of these elements. They need to remain agile and adjust to the current environment while taking care of all the different factors that affect lending decisions.