Many entrepreneurs start their businesses using their own capital. In some cases, business owners take out personal loans to get their company off the ground. Obtaining credit in the early stage of a company is much harder than obtaining credit once the business is already up and running. Traditional banks generally require the company to have been operating for at least 12 to 24 months, with consistent financial statements, before it can apply for a loan.
Access to credit remains a challenge for small business owners in Brazil and abroad. Many small businesses face difficulties and obstacles in obtaining bank credit, with approval rates considerably lower than those of medium-sized and large companies.
Another extremely important factor is the interest rate. In my opinion, the interest rate is the main reason why business owners decide not to take out bank loans.
The interest rate is the cost of borrowed money. In other words, it is the amount charged for the use of someone else's capital (when you borrow).
When interest rates are very high, there is a disincentive to apply for a loan, since the cost of the money will be very high. Often, it is simply not worth it for the business owner to grow their company at a very high financial cost.
The interest rate varies according to several factors, such as the borrower's risk. This means that companies with a better credit history secure better rates. Business owners who have assets, such as property, that can be offered as security (the ability to provide collateral) generally receive lower rates. A country's macroeconomic conditions, which the business owner cannot control, such as inflation and monetary policy, can also have an enormous influence on market interest rates.
Over the past 20 years, I have helped hundreds of small business owners apply for business loans from banks and other financial institutions in Brazil and abroad. Companies that have been in the market for years (more mature businesses) find it easier to obtain credit. A prior relationship with financial institutions should also be taken into account. It is therefore very important that business owners always maintain a good track record with their bank. For lending purposes, it is very important that the business owner manages the company's account as well as possible. It is no use the company having excellent turnover if the bank account is always overdrawn.
Nowadays, many lenders also take into account an analysis of the profile of a company's director and shareholder. It is therefore very important that the business owner and the company director keep their personal finances in order. Other lenders also look at the director's and owner's involvement in previous companies. If the same business owner has been involved in other companies with defaults, the bank may also refuse a business loan application.
Companies that keep their financial statements organised and up to date have a better chance of approval.
What is a business loan?
Lending is a subject that has always caught my attention.
Every loan always has two participants: the lender and the borrower. The lender lends the money to the borrower, who needs to use it properly to offset the financial cost of the loan. The cost of borrowing this money is what we commercially know as loan interest.
A business loan is a financial transaction in which a company obtains funds from a lender (such as banks, financial institutions or other credit providers), committing to repay that amount plus interest within a set period.
Business loans generally have defined purposes, such as expanding the business, obtaining working capital, buying assets, paying taxes, funding marketing campaigns or hiring staff.
What types of business loans are there?
There are several types of business loans. It is very important that business owners correctly identify which type of loan they want, so they can choose the right product according to their needs and intended use.
Let me give you an example: as a business owner, you should never, under any circumstances, use your company's overdraft to fund the purchase of goods from your suppliers. This financial cost would be astronomical and would drive your business to ruin.
Short-term financial products should be used for short-term purposes. If you, as a business owner, want to expand your business over the next 3 to 5 years, you can apply for a loan and repay your lender over 3 to 5 years.
If you need money immediately because it is a critical, emergency situation, but only for a few days to cover a negative balance in your bank account, you can use your bank's overdraft.
If you are looking to buy equipment with a long lifespan (generally more than 5 years), you can apply for a special financial product known as equipment finance (in English, asset finance).
If you want to buy a property, you should apply for a mortgage.
In short, you have to be certain that you will use the loan in line with the purpose stated in the application.
Types of Business Loans – secured e unsecured
There are essentially two types of loans: secured e unsecured. Secured loans are transactions in which the borrower provides an asset (most often a property, sometimes a car) as collateral. If the borrower fails to repay the loan, the lender has the legal right to take possession of that asset and sell it to recover the amount owed. Secured loans generally offer lower interest rates due to the lower risk for the lender.
On the other hand, unsecured loans do not require physical collateral, so there is nothing to be repossessed in the event of default. Unsecured loans generally carry higher interest rates due to the risk, even though they often require a personal guarantee from the business owner.
It is important to remember that, even if a business loan is unsecured, this does not necessarily mean that you (as a director or shareholder) will not be personally liable for repaying the loan if the company is unable to honour the payment. The vast majority of lenders in the market (traditional banks and other financial institutions) require the company's director or shareholder to be, ultimately, personally responsible for repaying the loan (this individual is also known as the guarantor of the loan).
Working Capital
This type of loan is designed to fund a company's day-to-day operations. Working capital loans generally have shorter terms than traditional loans. They usually run for 6 to 24 months and are ideal for covering operating expenses, stock and accounts payable.
Equipment Finance
This financial product is specifically for companies that want to buy machinery and equipment. In some cases, the asset being purchased itself serves as security for the lender. This type of finance allows for longer terms, generally aligned with the useful life of the equipment being purchased.
Invoice Finance
This product is very attractive for companies with invoices due to be paid over time. In the United Kingdom, this product is known as Invoice Discounting.
If your business takes debit or credit card payments, it is well worth considering the option of a Cash Advance. In the United Kingdom, it is better known as a Merchant Cash Advance (MCA). This financial product is a form of business funding in which a provider offers a cash advance in exchange for a percentage of the company's future sales.
Microcredit
This product is more common in some countries. These are generally smaller loans aimed at small businesses. The application process is simplified and approval is usually quick.
Revolving Credit Lines
This financial product is a credit line in which banks, for example, pre-approve limits on your account that can be used according to your company's needs. In this case, interest is paid only on the amount used. It is similar to an overdraft facility in Brazil, but generally with more attractive rates. As a business owner, you should avoid using revolving credit lines to fund expansion or stock purchases because of the high financial cost of maintaining and obtaining this type of credit.
Overdraft
This is a facility that allows a bank customer to spend more than they hold in their current account, up to a set limit. An overdraft is often used to cover unexpected expenses or to avoid bounced cheques. Interest is charged on the negative balance, and rates can be higher than those of a revolving credit line. An overdraft should be considered a short-term facility and, in many cases, is less flexible than a revolving credit line.
Who are the lenders providing business loans in the market?
Most business credit is provided by banks and other financial institutions.
In the United Kingdom, according to Bank of England publications, recent estimates put the share of external finance provided by banks to small businesses at between 70% and 85%, depending on the definition and the period analysed.
In Brazil, around 85% of business credit is originated by banks (universal/commercial banks and state-owned banks). Credit unions, finance companies, fintechs and other financial institutions account for most of the remainder.
In the United States, reliance on banks is very high: typically 60%–80% of SME credit goes through banks (including traditional facilities and SBA-backed operations). Fintechs, credit unions and non-bank lenders have been gaining market share, but from a smaller base.
That is why I always advise every business owner to have a business account not only with digital banks but also with traditional banks. Most digital banks are not authorised to provide loans.
Let us now look at the main lenders in the market and their individual characteristics.
Main Lenders in the Market
- Traditional Banks
- Offer a wide range of business credit products
- Usually require more documentation and security
- Tend to offer more competitive rates to long-standing customers
- More rigorous and time-consuming assessment process
- Specialised Financial Institutions
- Focused on specific segments or types of credit
- May have faster processes than traditional banks
- Usually charge higher rates than banks
- Credit Fintechs
- Use technology to simplify the lending process
- Assessment based on algorithms and alternative data
- Usually offer a fully digital experience
- May offer competitive rates to make up for the absence of physical branches
- Credit Unions
- Financial institutions formed by their members
- Often offer more attractive rates to members
- Tend to provide a more personalised service
- Development Agencies and Development Banks
- Offer credit lines on preferential terms
- Focus on regional or sector development
- Usually have subsidised rates and longer terms
What is the difference between the lenders above?
- Interest rates: Traditional banks and credit unions usually offer lower rates than fintechs and specialised financial institutions.
Traditional banks and credit unions usually offer lower rates than fintechs and specialised institutions because they have a lower cost of funding (through deposits and savings), economies of scale that dilute operating costs, and long-standing customer relationships that allow better risk assessment and more robust security requirements.
Fintechs, on the other hand, rely on more expensive capital from investors, serve higher-risk niches and need high returns to sustain growth, resulting in wider spreads.
- Speed: Fintechs tend to have faster processes than traditional banks.
Fintechs tend to have faster processes than traditional banks because they operate with 100% digital technology, automated decision algorithms that assess credit in real time, a lean organisational structure with less bureaucracy and a culture geared towards speed, enabling approvals in minutes or hours versus the days or weeks taken by banks. While traditional banks are held back by legacy systems, strict compliance processes, hierarchical structures with multiple approval layers and a conservative culture that demands detailed analysis, fintechs can offer an optimised mobile-first experience and purely data-driven decisions, creating a trade-off where speed makes up for higher rates, especially for urgent working capital, seasonality, operational emergencies or businesses that value agility above all else.
- Requirements: Development banks and development agencies often have specific requirements related to the purpose of the loan because their mission is to promote economic, social and sector development through public funds that must be applied strategically in line with public policies and legal mandates.
- Relationship: Traditional banks and credit unions value relationship history, while fintechs focus more on objective data.
Traditional banks and credit unions value relationship history, while fintechs focus more on objective data, because they represent distinct philosophies: traditional banks use qualitative analysis based on years of account activity, products used, the manager's personal knowledge and the business context, offering flexibility for atypical situations and tailored conditions, but with a slower process and a possible barrier to entry for new customers; fintechs, on the other hand, use machine learning algorithms that process quantitative data (scores, Open Banking, public information, digital behaviour) for automated real-time decisions, ensuring speed, democratised access and transparent criteria, but with rigidity for specific cases and limited context, creating a trade-off where relationships offer personalisation versus objective data that provides speed and scalability.
What are the reasons for applying for a business loan?
It is very important for the business owner to understand the real reason why the company is applying for a business loan. Each financial product has an ideal use depending on its purpose. Over the 20 years I have been advising companies in Brazil and abroad, I have seen many cases of business owners who applied for a financial product for the wrong reason. Many business owners end up applying for a long-term loan or working capital facility when the real need is short term. This means that obtaining the loan will cost an unnecessary amount of money for a temporary need.
Another very common mistake is financing a fixed investment with a short-term facility. In this case, the business owner has taken out a financial product that must be repaid quickly in order to buy, for example, a fixed asset such as a piece of equipment. This creates a timing mismatch between the loan repayment term and the investment's payback period, generating unsustainable pressure on cash flow and a high risk of default. Another common situation is when the business owner offers excessive security, unnecessarily putting their personal assets at risk.
The purpose of the loan will directly affect its terms, such as the interest rate, the repayment term, the security required, the grace period and the disbursement. The purpose of the loan will also affect the loan viability assessment, for example: repayment capacity must consider when the investment will generate a return, the projected cash flow according to the nature of the application, the risk of the operation as assessed by the lender, and the documentation required for each purpose.
Most common reasons for applying for a business loan
Below is a summary of the reasons for applying for a business loan:
1. Working Capital
- When to use:
- Financing day-to-day operations
- Purchasing raw materials and goods
- Paying suppliers
- Covering sales seasonality
- Balancing cash flow
Suitable products:
- Secured account/Business overdraft
- Revolving credit
- Receivables financing
- Invoice discounting
- Working Capital (international banks)
Characteristics:
- Short terms (30-180 days)
- Higher rates (faster turnover)
- Immediate disbursement
- No grace period
- Simple security requirements
2. Fixed Investment (Asset acquisition)
When to use:
- Purchase of machinery and equipment
- Construction or refurbishment of premises
- Technological modernisation
- Expansion of production capacity
- Acquisition of commercial vehicles
Suitable products:
- Machinery and equipment finance (Asset finance)
- Business CDC (Direct Consumer Credit for Businesses)
- Operating/finance leasing
- FINAME (domestic equipment) (Brazil only)
- BNDES credit lines (Brazil only)
Characteristics:
- Long terms (12-120 months)
- Lower rates (secured lending)
- Disbursement according to schedule
- Grace period before repayments start
- Robust security (the asset itself, guarantors)
3. Expansion and Growth
When to use:
- Opening branches
- Launching new products
- Entering new markets
- Acquiring other companies
- Internationalisation
Suitable products:
- Expansion loan (Business loan: bank and fintech)
- Regional development credit lines
- Export credit
- Private equity/Venture capital
- Debentures
4. Financial Restructuring
When to use:
- Renegotiating existing debts
- Extending repayment terms
- Reducing finance costs
- Consolidating liabilities
- Improving cash flow
Suitable products:
- Debt repayment loan
- Debt renegotiation
- Credit secured against receivables
- Structured transactions
When should the business owner avoid applying for a business loan?
Applying for a loan is not always the ideal solution for a business owner. I have known many business owners who applied for a loan when their company was already heavily in debt. In my opinion, companies caught in a debt cycle should avoid new loans at all costs. Very often the interest — or rather, the finance cost of the loan — can further compromise the company's operating result, driving the company deeper and deeper into debt. At the same time, many companies with structural profitability problems may take out a loan simply to mask their financial results and thereby hide the real problems the company has. These may be structural, process-related or fundamental problems.
Many business owners also apply for a loan and then withdraw the money for the shareholders, as if it were a distribution of profits. The business owner forgets that a loan is not income and should never, under any circumstances, be distributed as dividends. Using a loan to pay directors' remuneration or distribute profits to shareholders is madness.
I have known few business owners who understand the logic behind calculating the expected return on a loan. Let me try to explain. The expected return on a loan has to be greater than the cost of the loan. If the financed project does not generate enough return to cover the interest, it is not worth it. When the company is operating in times of great market uncertainty and revenue projections are therefore very unstable, or the country in which the company operates is going through a severe economic crisis, it is not advisable to apply for loans.
I have also known business owners who sought finance and applied for loans to fund extremely high-risk projects that lacked proper planning. These speculative investments, usually made without a feasibility study, are a recipe for disaster. I have known business owners who lost everything. As I mentioned earlier, a loan is also not the only solution for a company. In many cases other alternatives are more suitable — for example, negotiating payment terms with suppliers or even advancing receivables may be preferable.
What are the important factors when a business owner applies for a loan?
The most important factor that you, as a business owner, must take into account when applying for a business loan is repayment capacity. You should never apply for a loan if the company will not be able to pay it back. You must not forget to analyse the impact of the loan's interest on your company's financial results.
Many business owners end up accepting a loan simply because the money is available, and as a result they do not compare different offers in the market and end up choosing the most expensive option.
I always advise my clients to match the loan repayment term to the company's cash flow. It is very important to assess the impact of longer terms on the total cost. The effect of seasonality on the business must not be forgotten. In some situations, in the months with the weakest revenue, the company will not be able to make the loan repayment, causing discomfort and financial stress as well as penalty charges.
Many business owners forget to check whether the loan can be repaid early. It is very important to understand this possibility and make sure it has been included as a contractual condition.
I only suggest that a business owner provide a personal guarantee if there really is no other option available. Many business owners do not understand the risks associated with the security offered to lenders. It is very important to prevent the loan from creating an extremely stressful environment in the company because of the need to meet the monthly repayments.
That is why, in addition to the financial analysis, it is very important to define objectively how the loan proceeds will be used and not to forget to have a well-structured utilisation plan. Another question is: what happens when the company is late with a loan repayment? It is very important to understand what the late-payment penalties are. Once again, I will stress the importance of choosing the right product for the right purpose.
I currently have a network of people who work in traditional banks in several countries. I believe it is very important to maintain a good relationship with financial institutions. That said, there is no point in having a good relationship with people at financial institutions if you do not look after the financial health of the company and of its shareholders.
Nowadays, the loan application and approval criteria count for more than the relationship.
That is why the company's financial documentation must always be up to date. The financial statements must be current and well organised. It is essential to always have an up-to-date profit and loss record immediately available.
The Impact of Loans at Different Stages of the Business
Business loans can have transformative impacts, both positive and negative, on an organisation's financial and operational development, varying significantly according to the stage of maturity the company has reached in its growth cycle.
Early Stage (Startup)
Many entrepreneurs try to apply for a business loan to start their own business. However, the success rate is very low because the company has no track record. There are some exceptions to the rule in cases where the company's shareholder has assets available to offer as security. In some countries there are also government-backed schemes to help entrepreneurs and stimulate entrepreneurship in the country.. An initial loan can help get operations off the ground, allow investment in basic infrastructure and make market testing possible. However, taking a loan too early, at the initial stage of the company, can create financial pressure before revenue has stabilised, as well as creating a risk of early over-indebtedness.
Growth Stage
When the company is in its growth stage ( (on average 12 to 24 months in – it varies according to the business model), applying for a loan can accelerate the expansion of the business. It is very important to remember that once the company is in the growth stage, it has already proven (at least technically) that the business model works. Many companies cannot afford to miss out on market opportunities. A loan can be an option to finance an increase in a company's production capacity. However, it is very important to prevent the company from growing uncontrollably and accumulating too much debt. There are countless cases in which a company runs the risk of becoming over-indebted.
An over-indebted company is one whose level of debt is so high that it compromises its ability to meet its financial obligations. This basically means that the company's debts exceed its capacity to generate revenue, making it difficult or impossible to pay its creditors. In most cases, total debts exceed the company's repayment capacity or even the value of its assets.
In my professional career, I have come across cases where the company struggled to generate enough cash flow to cover interest payments and the principal of the debt. As a result, other lenders such as banks become reluctant to offer new loans or credit to the company, making its financial situation even worse. This debt overload can consequently lead to formal restructuring proceedings or insolvency.
Maturity stage
When the company reaches a more stable stage, it finds it much easier to obtain a loan. Many companies apply for a loan at this stage to finance the modernisation of the business and update their systems and technology. Other companies look at the possibility of diversifying their products, services or markets. I have also come across cases in which the company applied for a loan to enable a strategic restructuring of the business.
However, the purpose of the loan during this stage must be made clear. Applying for a loan can mask the decline of the business. Many business owners fail to keep up with the pace of innovation at this stage and end up becoming complacent. It is very dangerous to depend on credit to keep the company running during the maturity stage.
Many lenders expect the company to contribute a share of its own capital in modernisation projects. After all, the company has been operating for years and should already have retained earnings in the form of cash readily available for any eventuality.
Decline stage
This is the most dangerous stage for a company to take out a loan. A loan can give the company financial breathing space for a possible restructuring or even allow investment in new strategies. Many companies need to implement change as quickly as possible to overcome this stage of decline. However, a loan at this stage may only postpone many inevitable problems. It can also increase the company's debt at the very moment the company is most fragile, with the risk of worsening its financial situation if there is no structural change alongside the use of the loan. In my opinion, the business owner should think very carefully about whether to apply for a loan during the decline stage and avoid, at all costs, offering a personal asset as security.
Recovery stage
The recovery stage, often known as turnaround, revival or restructuring is not a sequential stage of the company's growth cycle. In reality, the recovery stage is the process in which a company tries to reverse a negative trend and return to growth or stabilise its key indicators. It is an intervention aimed at rescuing the company, pulling it out of decline and taking it back to either the maturity stage or the growth stage. In other words, the ultimate goal is to recover the company after implementing strategic actions. To give you an idea of the kind of actions we are talking about, here are some examples: cutting direct and indirect costs and increasing productivity (improving operational efficiency), repositioning the product or market, innovation, financial restructuring such as debt renegotiation and capitalisation, acquisitions or alliances with other companies or the sale of non-core assets, and finally a change of leadership or in the company's management.
In the companies where I was directly involved in the recovery, I only advised taking out a loan during the restructuring when the loan would be used solely to finance strategic actions that could immediately increase cash generation or reduce the company's operating costs. Otherwise, the loan could make the company's situation even worse and increase the risk of insolvency.
Once again, I would like to stress the importance of understanding the exact purpose of the loan — for example: temporary working capital, paying suppliers, revenue-generating investment, or paying off and renegotiating debts. If the loan improves the company's ability to generate cash in the short and medium term, I advise applying. Otherwise, no — it is better to avoid it. There is also no point in applying for a loan without a clear restructuring plan with clear targets, defined responsibilities and an implementation timetable. In this case, it is very important that the business owner and the consultant prepare cash flow projections with realistic scenarios. It is also important for the business owner to look at other, less costly alternatives with fewer obligations, such as shareholder capital injections, asset sales, invoice discounting and other investors.
On the other hand, I have also taken part in the recovery of companies that obtained loans which financed actions that accelerated the company's recovery, such as purchasing strategic raw materials and marketing to relaunch sales, among others. Obtaining a loan can prevent operations from being interrupted, preserving the company's value. Meanwhile, the business owner and the consultant can buy time to implement these strategic recovery actions.
If the business owner has genuinely decided to apply for the loan, it is very important to ask for a grace period, because high repayments can suffocate the company's cash flow. Negotiating the interest rate is essential, since a high rate can reduce the positive effect of the cash received.
As I mentioned earlier, it is very important to analyse the situation very carefully when the lender asks for security, since security offered to lenders can, in the end, put the business owner's personal assets at risk if the recovery does not happen.
To sum up taking out a loan at the recovery stage: only take out a loan if it is an integral part of a viable restructuring plan — that is, to finance actions that measurably increase revenue or reduce costs — and if the credit conditions, such as the grace period, term and interest rate, do not compromise the operation. Otherwise, prioritise renegotiation, capital injections or other operational measures before taking on new debt.
Summary of taking out loans during the stages of the company's growth cycle
In short, a business loan works as financial leverage. The business owner can use third-party capital from banks and other lenders to seek to boost the company's results while preserving their own capital for other needs. There are many success stories in which taking out a loan enabled a company that had been working solely with its own resources to grow faster. However, it is very important to analyse the impact of the loan on the company's financial results, because the finance cost of a loan will reduce the company's profit margin. It is essential to avoid at all costs letting the company become over-indebted and to avoid constant pressure from loan repayments on the company's cash flow.
How do banks carry out their analysis? What analysis methods and calculations are used to decide whether to approve a business loan application?
Many banks offer loan applications automatically through their online systems. Many companies already have a pre-approved loan in the customer system. However, it is very important that the business owner understands the analysis methods used by lenders such as banks.
I would like to divide the data analysis methods used by lenders into the 8 items below:
Analysis methods used by lenders
- Analysis of financial statements
It is very important that the business owner keeps the company's official accounts up to date. Lenders will analyse the balance sheet, the company's profit and loss statement and, in some cases, the cash flow statement as well (even if it is not included in the accounts). Regarding the balance sheet, it is very important to understand how the company's assets and liabilities are distributed — or rather, how the company's rights and obligations are distributed.
It is also very important to understand how the assets are structured between current and fixed assets. As for the company's obligations, it is very important to understand whether the company has accounts payable and loans, and what its short-term and long-term obligations are.
The company's profit and loss statement is very important for analysing the company's ability to generate profit. The likelihood of a lender granting a loan to a loss-making company is very small. Lenders are generally looking to lend to companies seeking to expand and grow their business. These companies therefore have to show a positive track record. In my opinion, this track record should cover at least two years.
Cash flow is extremely important for verifying the company's ability to repay the loan. It is very important to understand how the company's managers have been managing its cash flow. If the lender notices, for example, that the company's managers/shareholders are making excessive withdrawals or not managing the company's cash properly, it is very likely that the lenders will not approve the loan.
- Financial ratios
The ratios most commonly used by lenders to analyse a company's loan application are: liquidity, gearing, profitability, stock turnover, and average collection and payment periods.
In the case of liquidity, the lender wants to know the company's short-term repayment capacity. Here, the ratio between current assets and current liabilities will be analysed. To put it more simply: is the company generating enough cash to pay its short-term obligations?
As for gearing, the lender will want to know the proportion of equity that the shareholders or owners have invested in the company versus what came from third-party capital.
Third-party capital refers to the financial resources a company obtains from external sources that do not belong to the company's owners or shareholders. This capital is used to finance the company's operations and investments. It generally includes: bank loans, other contracts with financial or credit institutions (financing), credit provided by suppliers, and other forms of credit such as leasing.
As for the year's results — or rather, the profitability of the business — it is very important to understand whether the company is able to generate profit or not. If the company is not generating profit, it is very important to understand why.
If the company sells products, it is very important to understand the average collection and payment periods for stock.
- The 5 C's of credit
Many lenders use the 5 C's of credit analysis technique. Basically, the lender will assess the following 5 C's of the applicant — in this case, the company:
- Character: payment history and market reputation
- Capacity: the ability to generate sufficient revenue
- Capital: own funds invested in the business
- Collateral: security offered
- Conditions: external factors affecting the business
- Analysis of the ideal debt limit
I usually say that a small business can take on debt of at most 30% of its annual turnover (with a 5-year repayment term). Obviously, this percentage varies from company to company, depending on the business model, the sector in which the company operates and the terms/characteristics of the loan.
Doing a simple calculation, let's say your company has a turnover of £ 100,000. In this case, the maximum loan amount would be £ 30,000.
As I have mentioned several times before, it is very important to analyse the impact of interest on the company's operating result. If the company does not have the financial capacity to repay the loan, it is better not to apply and to look for another way out. Over-indebtedness only complicates life for the company and the business owner.
- Project viability analysis
It is very important to calculate the return on investment of the project the lender will finance. The business owner should know how long it will take to recover the investment — better known as the payback period.
- Behavioural credit analysis
Many lenders want to know a bit more about the relationship history the business owner has with banks and other financial institutions. And the business owner's profile, once again, is very important: if the business owner does not manage their personal life properly, there is a strong chance the company will not be managed properly either. If the business owner does not pay their bills on time, it is very likely that the company will not pay its bills on time either. Many lenders want to know whether the business owner has taken out a loan in the past and made the previous payments on time. I have even seen a bank analyse the company's relationship with suppliers and customers.
- Sector and market analysis
Some lenders favour certain sectors over others. There are some sectors the lender prefers to avoid because of the risk. It is therefore very important for the business owner to ask the lender in advance whether the bank has any requirements, prohibitions or restrictions relating to the sector in which the company operates.
- Documentation and Records Check
It is essential that the company's tax affairs are up to date with no amounts outstanding. All traditional banks run a credit check with the reference agencies. If the company has legal irregularities, open or adjudicated lawsuits and legal problems, it is very likely that the lender will not lend the money.
Important Calculations in Credit Analysis
Below is a description of the important calculations that lenders (such as traditional banks) perform on companies when a loan application is made.
1. Repayment Capacity:
- Profit before tax (-) Dividends + Depreciation + Amortisation > 1.5 × the annual loan repayment amount.
Example:
Profit before tax = £ 100,000
Dividends = £20,000
Depreciation = £ 5,000
Amortisation = £0.00
Calculation: £ 100,000 – £ 20,000 + £ 5,000 = £ 85,000
Company turnover £ 300,000
Loan £ 60,000 (5 years)
Annual interest 10% per year.
Annual loan repayment amount £ 15,828
£ 85,000 > 1.5 × £ 15,828 = £ 23,742.00
In our example, the £ 60,000 loan would be accepted.
2. Gearing Level:
- (Total Debts ÷ Annual Turnover) × 100% < 30%
Let's calculate it for our example:
£ 60,000 / £ 300,000 × 100% = 20% < 30%
In our example, the gearing level is within the limit.
3. Debt Service Coverage Ratio:
- EBITDA ÷ (Interest + Principal repayments) > 1.5 (recommended)
Let's calculate it for our example:
£ 100,000 ÷ (£6,000 + £ 9,828) = 6.31 > 1.5
4. Impact of the Loan on the Results:
The company has to generate enough profit to be able to repay the loan.
- Profit Before the Loan – Loan Interest = Profit After the Loan
- If the result is negative, the loan is probably not viable
Let me give you an example:
Negative Example:
A company generates annual sales of £100,000 and has total administrative expenses and costs of £85,000. It applies for a loan of £80,000 to be repaid over 12 months, at an interest rate of 30% per year. Let's calculate the impact on the company's profit and loss before and after the loan:
Before the Loan:
- Total Sales: £100,000
- (-) Administrative Expenses and costs: £85,000
- Total Profit: £15,000
After the £80,000 Loan:
- Interest (30% per year): £24,000
- Total Sales: £100,000
- (-) Administrative Expenses: £85,000
- (-) Loan Interest: £24,000
- Total Expenses: £109,000
- Total Loss: (£9,000)
As you can see, the impact of the loan on the company's financial performance is negative. In this case, the loan would not help the business at all.
Positive Example:
The same company applies for a loan of £30,000 with the same term (12 months) and interest rate. Let's calculate the profit and loss again:
Before the Loan:
- Total Sales: £100,000
- (-) Administrative Expenses: £85,000
- Total Profit: £15,000
After the £30,000 Loan:
- Interest (30% per year): £9,000
- Total Sales: £100,000
- (-) Administrative Expenses: £85,000
- (-) Loan Interest: £9,000
- Total Expenses: £94,000
- Total Profit: £6,000
Now you can see that the company remains profitable. This is the calculation you should always do before applying for a loan.
Important Comments about Loans
Once you understand the theory above about how loans work, I would like to make a few comments:
- A loan is not a sale. A loan is not income and a loan is not a gift
You must use the loan carefully and not spend it however you like. I have seen many company directors and shareholders applying for loans just to withdraw the money as salary or dividends. They end up paying a very high price to pay themselves. In fact, applying for a loan for this reason is pointless. The situation becomes even worse if the company is not making a profit.
- Make sure your company can afford the loan repayments.
If the company is not making a profit, you may end up in a debt cycle. A debt cycle is a situation in which the company has so many loans and other debts that it can never pay off the full amount owed, since the interest and repayments are too high.
This means the company does not generate enough money to cover the monthly repayments of the borrowed amount. Late payments also incur fines and additional charges. For trading companies, the loan should have a limit: it should not exceed an appropriate fraction of sales volume, according to the nature of the business.
Tips for Applying for a Loan
What to Do:
- Understand the different types of loans available;
- Always check the interest rates before signing a loan agreement;
- Decide on the loan repayment term (for example: 12, 24, 36, 48 or 60 months);
- Make sure your company can afford the repayments;
- Research information about the lender;
- Keep your company's profit and loss records up to date;
- Define the purpose of the loan (for example: expanding the business, working capital, buying assets, paying taxes, acquiring new customers, marketing campaigns, covering one-off costs, developing a property, hiring more staff);
- Consult your accountant about the loan options;
- Keep your company's credit report in good standing.
What Not to Do:
- Do not forget to calculate the maximum loan amount your company can afford;
- Do not apply for loans to finance company purchases (try extending credit terms first);
- Do not apply for loans to cover temporary cash shortfalls (try an overdraft first);
- Do not apply for loans if your company still has large amounts receivable from customers (try invoice discounting);
- Do not forget that your personal credit history can affect the approval of your business loan.
