Last week, Jeff Crook from Village Bank joined us to discuss business financing options with banks. We explored three main types of financing: credit cards, lines of credit, and term loans. This session was designed to help business owners determine which option may best suit their needs and how to prepare when seeking financing from a bank.

Credit Cards

• Simpler underwriting
• Easy to use
• Higher interest rates compared to other types of business loans (riskier if payments are missed)
• Earn rewards points

Credit cards are a convenient option for new businesses looking to establish credit. They’re best for mid-level purchases (typically under $5,000), which don’t require a depreciation schedule. Additionally, rewards earned from credit card use can be redeemed for other business expenses, making them attractive for cost-conscious businesses.

Lines of Credit

• Flexible transfers between the line of credit and your bank account
• More thorough underwriting
• Annually renewable, often with a renewal fee
• Best for managing cash flow cycles
• Not ideal for long-term financing needs

Lines of credit are perfect for businesses facing cash flow gaps—especially those needing to cover expenses before revenues come in. For example, a business paying a deposit for products manufactured overseas may need time to recover those funds after selling the product. However, it’s important not to rely on lines of credit for the long term, as they typically come with higher interest rates (currently around 9%).

Term Loans

• Used for real estate, business acquisitions, vehicle and equipment purchases, and long-term working capital
• Similar underwriting process to lines of credit
• Requires monthly principal and interest payments
• Aligns the loan term with the lifespan of the asset (e.g., a 10-year loan for a vehicle expected to last 10 years)

Term loans are ideal for larger, long-term purchases and require more due diligence from both the business and the bank. These loans typically offer more favorable interest rates, currently around 6-7%, which makes them a cost-effective choice for businesses financing long-term assets.

What Do Banks Review During Underwriting?

When applying for financing, banks focus on these key documents and metrics:

1. Three years of business tax returns
2. Current interim financial statements (balance sheet, profit & loss statement, A/R aging)
3. Three years of personal tax returns for the guarantor
4. Personal financial statement
5. Personal credit report for the guarantor

One of the most important metrics banks assess is the Debt Service Coverage Ratio (DSCR), which measures a business’s ability to repay its debt. Most banks look for a ratio of 1.2x or higher.

Here’s an example of a Debt Service Coverage Ratio calculation:

Net income: $45,000
Depreciation: $5,000
Cash Flow: $50,000
Annual Proposed Loan Payments: $35,000

DSCR Calculation: $50,000 / $35,000 = 1.42x

Frequently Asked Questions

What if I’m a new business and don’t have three years of tax returns?

There are still options:

1. Bootstrap with a credit card but be sure to carefully plan purchases and ensure you can repay commitments.
2. In some cases, banks may accept personal and guarantor financials to start the process.

Additionally, new businesses can explore the SBA 7(a) loan, which is a versatile loan designed to support both startups and established small businesses. It offers flexible financing for working capital, equipment, and real estate. Learn more about the SBA 7(a) loan here.

What if my personal or business credit score is poor?

Banks typically look for a credit score of 680 or higher. If your score is lower, you may still have options, but it’s a good idea to work on improving your credit through remediation or credit-building programs to increase your chances of securing financing.

Common Pitfalls to Avoid

Jeff also highlighted common mistakes that borrowers make when seeking financing:

• Failing to stay updated on changes to credit reports
• Neglecting liquidity and equity on the company balance sheet
• Misusing credit cards and lines of credit for unintended purposes
• Not building personal wealth outside the business
• Failing to diversify customers and vendors
  

How to Keep Banks Happy

Finally, Jeff shared some tips on maintaining a good relationship with your bank:

• File tax returns on time
• Invest in a good bookkeeper and CPA
• Maintain consistent communication with your bank
• Address potential issues early on
• Provide referrals when possible

We’re grateful to Jeff Crook and the Village Bank team for sharing these valuable insights with our members.