Making a Credit Application

One of the biggest problems facing small businesses today is the apparent lack of access to adequate sources of capital. Many small business owners are forever complaining that banks simply won't lend them the money they need to survive and prosper. To support the argument small business owners point to statistics on loans to small businesses. Like all other businesses, banks exist to make a profit. To be profitable banks must use discretion when selecting those to whom they'll lend money. The balance of risk and return is always paramount. Lending decisions are based on a borrower's credit worthiness. Credit worthiness is evaluated using information obtained from an application, which the borrower completes to begin the lending process. Financial institutions generally look at several factors in determining credit worthiness. These include the borrower's:

• Character
• Collateral
• Capital
• Conditions
• Capacity to repay

Character, in this context, refers to the degree to which a potential borrower feels a moral obligation to repay his debts. The best barometer of this commitment is the borrower's credit and payment history. Information regarding a person's or business's previous payment patterns can be obtained from suppliers, banks, credit card companies or collection agencies.

The capacity to repay is a determination made by a lender on whether a borrower has the ability to satisfy a loan. Capacity to repay is a subjective determination based on analysis of objective financials. Lenders examine financial statements, financial ratios and operating data to aid their decision.

Lenders also look at a firm's capital in determining whether to grant a loan. The amount of capital in a business is equal to the net value of its financial obligations, including both debt capital and equity capital. Measures of capital include financial ratios such as the debt-to-asset ratio, the current ratio and the debt-to-worth ratio. Lenders prefer low debt-to-asset and debt-to-worth ratios, and high current ratios. These indicate financial stability.

The primary consideration of a lender is: "Will I be repaid?" As a guarantee against nonpayment, lenders often require that borrowers make a pledge of collateral. Collateral is an asset owned by a borrower, but promised to a lender against nonpayment of a loan. If a borrower defaults on a collateralized loan, the lender takes title to the collateral, liquidates it and uses the proceeds to pay the loan. The amount of collateral required for a given loan varies from lender to lender and from borrower to borrower. However, the closer collateral values are to 100 percent, the better the lender is assured of ultimate loan repayment.

A final item that most lenders analyze are the conditions in which the borrower operates. These includes general economic, geographic and industry conditions. Lenders want to loan money in an "up" economy, and they want to loan money to businesses in industries that are growing and expanding.

To obtain a loan, a potential borrower must give the lender a feeling of confidence. The successful borrower will address all of the lender's concerns regarding character, capacity to repay, capital, collateral and conditions. Their loan application will say to a lender: "This is a professional company with an honest reputation, a good credit history, reasonable financial statements, good capitalization and adequate collateral."

In short, the credit application will tell the lender that making the loan is a "low risk" proposition.

Author: U. S. Small Business Administration
Source: U. S. Small Business Administration
Description: Making a credit application

This article is reprinted from the Small Business Forum, the journal of the Association of Small Business Development Centers, which is published by the University of Wisconsin-Extension Small Business Development Center. For information about subscriptions, reprints or submissions, please write to us at 432 North Lake Street, Room 425, Madison, WI 53706, or call us at (608) 263-7843