When considering a candidate for a loan, a lender is interested in the five factors of credit: character, capital, capacity, collateral and conditions. These standards help determine whether an applicant is capable of meeting the loan terms. Following is part two of a five-part series discussing these credit factors.
After the initial step of showing good character through strong credit history and a clean background, the focus shifts to capital. Essentially, capital is your assets vs. liabilities. Capital allows a lender to see how much an applicant has personally invested in a business.
Your balance sheet is a helpful tool to calculate capital since it shows assets, liabilities, and net worth. Assets can be turned into capital and are typically broken down into three categories: current assets, intermediate assets and long-term assets. Current assets have the ability be converted into cash within the business year. This could involve cash savings, stocks, or inventory such as cattle or crops. Intermediate assets include machinery, vehicles or breeding inventory, and can be converted into cash but may take longer than a year. Long-term assets are property that will be held for a long period of time such as real estate. Once all assets are compiled, the same should be done with liabilities. Finally, calculate your net worth, also known as owner’s equity, by subtracting liabilities from assets.
Many lenders look at net worth in relation to how much the owner has personally invested in the business. A lender wants to see that if a business goes through a tough time there will be a cushion to fall back on. Owner’s equity is like insurance for a lender. It shows that a borrower is fully committed to the business and will work hard on a turnaround if necessary.
In order to establish the percentage of equity and debt a business uses to finance its assets, a lender might use the debt to equity ratio. To find this ratio, divide total liabilities by total owner’s equity. The formula establishes how much the individual is leveraged or indebted. Generally, any percentage over 40-50 percent will be looked at more closely because it means the applicant has more debt than assets.
If you want to improve your debt to equity ratio, the simple solution is to pay off debt and be wary of non-income producing assets. Savings accounts are currently earning around 1 percent interest and liabilities are accumulating around 7 or 8 percent interest, using extra cash to pay off debt could be beneficial. However, it is important to maintain appropriate levels of working capital to run your day-to-day business. Working capital is current assets minus current liabilities, and paying off too much debt with current assets could drain working capital causing cash flow problems. Additionally, be cautious of investing in non-income producing assets, such as lake houses or boats. Sometimes these particular assets can also be a drain on cash flow without adding full value to net worth.
Ultimately, lenders want to see that you are fully devoted to the success of your business. By maintaining adequate levels of capital and keeping your debt to equity ratio low, you will be well on your way to a successful loan approval process. To learn more, contact your local FCS Financial lending specialist.
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