Credit is the lifeline of any business without which many of your business plans will remain just that; plans.
Perhaps you have approached your bank for a loan, or are contemplating doing so but you feel unprepared to initiate a fruitful credit discussion with your bank. Do you feel as if the process has been reduced to a document-collection exercise?
You are not alone.
And now your business has been adversely hit by the Covid-19 pandemic. It’s likely that you require cash injection to keep your business afloat as you craft a fresh strategy to maneuver back to profitability. But you dread a loan decline and loathe the entire process.
If that’s you, worry not. You’re in safe hands.
In this article, I’ll show you the common borrowing needs of small businesses and proven preparation tips for a constructive credit discussion with your banker. You can look forward to this voyage.
Let’s delve in.
Your borrowing cause determines how you’ll prepare to borrow. Here are the main reasons why you borrow for your business
4 Reasons Why Successful Businesses Borrow Money
1. Working capital Financing
You need cash to support your routine operations, particularly where you sell on credit. As a small or medium-sized business, your customers will either be retail or wholesale buyers, the latter often being corporate typically purchasing goods on credit.
Retail buyers consist of walk-in clients ordinarily purchasing small quantities with payments settled in cash.
When this segment makes up a considerable proportion of your clientele your cash flows or sales should be able to cover the daily costs of running your business.
That means you’ll be able to pay for utilities, restock and pay salaries from sales proceeds. Your working capital needs are pretty well covered. Right?
Corporate customers, despite making huge purchases and bringing your business decent profits, can potentially cripple your company’s operations by interrupting your cash flow cycle.
These companies are characteristically made up of government ministries, parastatals, and large institutionalized organizations, e.g. local and multinational corporates. They can turn your business into a living paradox where you are profit-rich but cash-poor.
“How would they do that?”, you may ask.
A Practical Example
Your company Build With Us Ltd deals in construction material. You’ve purchased cement worth $10,000. You supplied the cement at $13,000 to a corporate, Big Builder Ltd, who is a contractor working on a massive road construction project. You’ve made a cool gross profit of $3,000 from the transaction. But before you can laugh all the way to the bank, you remember their payment terms; 45 days after delivery.
That’s the catch 22 situation I was referring to; profit-rich, but cash-poor.
Although you have struck the right cord by bagging a lucrative deal, the reality is that payment is a whole 45 days away.
In the meantime, you have to restock, pay salaries, and utilities… NOW and not 45 days later.
You need working capital financing to keep you in operations until the day when you’ll be paid
If that ain’t bad enough. Think of a scenario where you have two other such customers… and they shop from you several times in a month.
I’m sure you’ll need working capital financing.
Generally, Working Capital can be structured variously based on your borrowing need. Here are 3 such examples; invoice discounting, and trade financing.
Read on to find out more
a) Overdrafts Credit Lines
A standby credit limit allowing you to overdraw your account to meet emerging trading needs such as restocking, payment of salaries, and other utilities as earlier discussed.
You can access the cash from this facility and service new orders as you await your invoices to mature.
b) Invoice Discounting
The bank will advance payment for contracts that you have successfully completed, with invoices raised and by acknowledged your buyer. This immediately avails cash upon project completion as opposed to waiting for the maturity date of credit terms stated in the contract.
To get a better understanding let’s again consider your company Build With Us Ltd
You supplied Big Builders Ltd with cement worth $13,000. They acknowledged your invoice. Their terms of payment as per contract is 45 days upon invoicing them. Big Builders Ltd is a reliable corporate but your business can’t wait for 45 days. What do you do?
Approach your bank to advance a portion of the amount on the invoice to enable you to continue operations. They’ll be interested in the creditworthiness of Big Builders Ltd and whether they can make an undertaking to directly channel payment to your bank account with them.
Voila, they’ll advance you cash NOW based on the expected payment 45 days later.
c) Trade Financing Solutions
These solutions may target local trade, international trade, or both & include bank guarantees, bid bonds, performance bonds, and letters of credit.
Guarantees and Bonds; very common when bidding for contracts. Quite relevant to your business. But what exactly are they?
Let’s find out
i) Bid Bond
XYZ Ltd has issued an open tender for the construction of 100 housing units. They’d want to attract serious bidders only. Those with the capacity to handle such magnificent projects.
Every bidding company is asked to provide a bid bond, which guarantees compensation to XYZ Ltd should a company win the tender and fail to start the project. This automatically weeds out casual contenders incapable of delivering the project.
In our case, let’s say, Build With Us Ltd wins the contract.
ii) Performance Bond
This is a guarantee issued by Build With Us Ltd to XYZ Ltd guaranteeing that they will indeed complete the project as per the agreed specifications.
You, that is Build With Us Ltd, can obtain the bid and performance bonds from your bank. For some consideration of collateral or on the basis of your business relationship, your bank will guarantee payment on your behalf to XYZ Ltd should you fail to start the project (for Bid Bond), or should you fail to complete the project as agreed (Performance Bond amount will be credited to XYZ Ltd)
That was quite detailed. But don’t go yet. I’m sure you wouldn’t want to miss the stuff that’s coming up next because we are shortly crossing borders shortly.
Get your passport ready.
When you source for goods from international markets (importation) or sell them abroad (export), you may require financial intervention to manage your cash-flow and mitigate risks associated with international trade.
Importing and exporting goods will usually take longer than sourcing locally. These time-lapses could lock up your cash in a complex web of transactions thereby creating a working capital financing need.
Likewise, there are myriad other risks such as exchange rate fluctuations, verification of quantity and quality of goods agreed on, accidental damage during shipping, and credibility of the buyer or seller.
Without the intervention of international mediators, they’d be no recourse if you’re scammed in import/export situations.
We will not delve deeper into these…you can breathe a sigh of relief…but it’s worth mentioning that letters of credit are a key enabler of international trade transactions. And a short definition won’t hurt.
iii) Letters of Credit (Documentary credits)
These are issued by banks or sometimes by special trade finance institutions. They are financial, legally binding instruments, that guarantee payment to the exporter if the terms on the letter of credit are fulfilled.
Enough of that.
Let’s check out another common borrowing cause
2. Business Expansion
Your business has been doing well but you believe you can do better. You have identified growth opportunities.
Expansion can come in various manifestations;
a) You May Open up New Branches
You’re prospecting opening a new branch on the next street or in a faraway town….or even across international borders.
You’ll need financing. You can fundraise from your own sources and supplement external financiers like banks.
Growth is exciting but can be undoubtedly stressful if not properly planned.
While planning an expansion, budget for the extra costs of leasing new premises, customization of the premises for functionality and to reflect your brand, additional staff where applicable and purchases of stocks, licenses, and local authority approvals.
You may also need to purchase and transport new machinery, add the traveling costs to manage these branches.
Factor in marketing costs to advertise your new branch and promote the brand where it may not be well-known.
Discounts to attract new customers, although necessary, are a cost that must be budgeted for.
Will you need to transport equipment to the new branch? That’s another cost.
These pointers will assist you to prepare a breakdown of costs to the bank for your loan request.
Expansion may involve product or service diversification.
Diversification may be based on products or strategy.
In product diversification, your company Build With Us Ltd may upscale into the importation of construction machinery besides its current business of selling building materials.
Diversification may also involve incorporating a new franchise such as a new clothing line if you’re into fashion. The same branch housing additional products. Makes sense?
Other examples; a cargo-only transporter moving into passenger transport, or a hotel adding new cuisine to its menu, or a car seller diversifying to include lorries, etc
Strategy diversification involves a dynamic shift in the product offering or service delivery architecture, e.g diversifying to engage in both wholesale and retail while maintaining products.
If you find opening up new branches and starting them from scratch being too cumbersome, there is another road that’ll still get you to Rome.
- c) Acquisition of other businesses
These are businesses that have built up goodwill and a clientele base that you just inherit by purchasing them. Buying out competitors can swiftly increase your footprint in the market. Sounds exciting?
But don’t move in too fast.
Before you invest a dollar in that company, find out why they are selling.
It’s prudent to establish future business viability of the enterprise you are about to acquire lest you end up with a sterile business shell.
Another thing; scrutinize the motive of the seller and listen to your gut feeling.
And finally, we take loans …
3) To Acquire Assets
Some assets are necessary for your business to perform better but are currently unaffordable.
Let’s go back to your company Build With Us Ltd. Construction materials must be transported from quarries to the depot or to customers. You’ll need transport whether or not you buy a lorry for the job. You have a choice to pay the bank for your lorry or pay a lorry owner for transport services.
Consider the opportunity cost involved in not buying the lorry. Compare the amount you spend on transport to the loan repayments if you acquired the lorry by bank financing. If you owned the truck could you create more revenue? A delicate balancing act; it’s up to you.
Bank financing can enable you ;
- Acquiring assets; movable assets such as motor vehicles and movable machinery
- Buy business and personal property through mortgage financing
- Acquisition of plant machinery
You acquire and use assets now to generate profit and pay slowly later as your business grows.
8 Proven Tricks to Prepare for a Credit Assessment
1. Assess Your Borrowing Need
The borrowing causes discussed earlier can be a good guide to establish your credit need
2. What was the Fate of Previous Borrowing Applications?
Have you had a previous loan deferred or declined? What issues were raised? Have you addressed them?
Were you negatively listed by credit reference bureaus? Have you obtained clearance for the items for which you were listed?
Was the loan declined due to business financial performance? Detect the cause of financial under-performance. Is it financial indiscipline or other underlying macroeconomic issues that you have no control over, such as Covi-19-pandemic-related business interruption?
3. Inherent Business Risks
Are there inherent risks such as weak ownership structures. Common in family businesses that are sole-proprietorships or partnerships.
Lack of effective succession planning presents a risk that must be mitigated as the lender sees his payments in sustainable business performance in the future.
Think of a business that is solely owned and the proprietor is health-challenged and there are no sound business succession plans. The lender is likely to decline the request, understandably.
4. Industry Risks Assessment
Since repayments are in the future profitable cash sales of your business, the industry life -cycle is key. Is it approaching the decline stage? Are industry products or services approaching obsolescence?
Maybe new legislation is about to render irrelevant an entire industry. Would you proceed to lend to a polythene bags manufacturer if the government will be banning the product in the next 6 months? Most probably not…unless they have a solid, actionable repositioning business plan to invest elsewhere.
Adaptability to change is imperative for business survival.
5. Prepare Relevant Documents
Although requirements differ with different jurisdictions, financing institutions and the type of financing required, the best practice is to provide the following documents:
- A Company profile (a good company profile; mentions key directors, their competencies, company’s business strategic intent, products, achievements, portfolio, aspirations, etc)
- Relevant company registration documents showing current ownership, and borrowing powers
- Draft the Loan Request Letter: state the amount sought, the purpose of the borrowing, how you intend to pay back, and the repayment period. Attach relevant testimonials, e.g if applying for invoice discounting then attach the invoices, and contracts, and undertakings to pay when required to do so.
- Financial Statement: current bank statements; audited financials and/or management financials where they’re still not ready, cash flow projections-remember the bank depends on your future profit cash outflows to pay the loan
- Proposed collateral: Avail copies of ownership documents for proof of ownership eg title deed for landed property or logbooks for motor vehicles, current property valuations if available
Hint: It’s unbelievable how this simple hint can save you tons of time:
Ask your banker for their bank’s checklist to ensure your collection of documents is exhaustive and compliant with their internal processes. This will reduce the back-and-forth in document submission speeding up the entire process.
6. Shop for Appropriate Financier
What’s the bank’s strategic lending focus?
Banks, just like other businesses, tend to have niches they specialize in. For some it’s small business lending, others focus on multinational deals, others prefer short-term lending, etc.
Check if the bank’s focus is aligned to your borrowing cause or segment. This can be an invaluable time saver.
Another key; try your bank first. As a loyal customer, you have history and a relationship (hoping it’s a good one) with them. If the strategic lending focus is aligned to your need your chances are higher there. Negotiate for available discounts for loyal clients.
7. Prepare Well for a Site Visit by the Bank
In banking, there is a mantra that goes; trust but verify.
Sometimes, the bank may be interested in making a site visit to verify facts on the ground. I have witnessed interesting engagements where a client had a great business on paper, but in reality, it was a ghost business.
If you do online business the site visit may be a bit different. But it may still be an actual site (pun intended) visit…on your website…to verify your claims.
In the traditional business setting. You don’t need to create a fictitious environment to suggest that business is booming. You know your business well so try to schedule for credit interviews when it best suits you. When you are too busy you won’t hold constructive discussions. Strike the right balance.
I’ve had instances where bank clients “hired” customers to their shop during site visits to show their business was doing really well. How ridiculous? Working as a bank relationship manager can be hilarious.
8. Establish a Good Working Relationship with your Banker
“The way we communicate with others…ultimately determines the quality of our lives.”– Tony Robbins
Relationships open door that volumes of financials solemn would.
Promptly respond to queries raised by the bank. Don’t be antagonistic. Stay optimistic. They are seeking clarity so as to accurately assess your request. Querries do not mean a loan decline. Not being transparent raises questions that impede a prompt approval decision in your favor.
As you’ve taken this voyage with me, you’ve explored the reasons why your business needs financing. You’ve also noted the various financing structures under which the financing may be availed to your business.
Finally, you’ve seen how to concretely prepare for a loan interview. You no longer need to view these interactions as a process that must lead to an approval in exactly the way you desire. A discussion around your borrowing needs unearths many patterns in your business gifting you a valuable goldmine to craft a winning and sustainable strategy for your business.
Remember that a loan decline is not always bad; you get an opportunity to review your business with some outside view, and you get to understand what needs fixing (be it ownership structures, need for diversification of products, financials, debt-burden ratio, the loan structure). Business analysis that reveals the weakness in a structure is not to be abhorred but must be celebrated by all and sundry who are hell-bent on fixing the cracks for a better sail in the days ahead.