• Working-capital lines of credit.
• Equipment term loans.
• Equipment leasing.
• Commercial real estate loans.
• Commercial term loans.
• Government-guaranteed loans.
• Personal loans.
• Revolving lines of credit.
• Letters of credit.

Working-capital lines of credit are the most common form of secured loan available to growing businesses. They are tied directly to the receivables or inventory levels of the borrowing company. These loans provide funds that can increase as sales increase, while providing the bank with collateral that can easily be liquidated (that is, turned into cash in case of default on the loan). Working-capital financing is normally contracted for a year and may be renewed for additional periods by the lender. The borrowing arrangement will have a stated maximum amount and will be limited to an agreed-on percentage of the assets being pledged as collateral. The interest rate on these lines of credit will usually be variable and fluctuate with the prime rate. There are two primary types of working-capital lines:

 

Accounts-receivable financing is usually limited to between 75% and 85% of the eligible receivables balances (typically receivables less than 90 days old). Thus, as sales are made, a significant portion of the unpaid invoice can immediately be converted into cash. As amounts are collected from the customer by the company, the loan is paid down or new receivables are pledged as collateral for the loan. Receivables financing thus provides a revolving line of credit in which funds are continually advanced, repaid, and readvanced.

 

The key factors for you in obtaining receivables financing are determining the receivables that are eligible for the loan and the percentage that will be advanced. To do this, the bank will conduct a thorough investigation of your company, reviewing such items as your customers' credit histories, the types of receivables, and the quality of the accounts. The better the condition of your receivables (e.g., a small number of accounts outstanding over 90 days and good customer credit ratings), the more the company will be allowed to borrow against those accounts. You should have a credit résumé for each of your customers to aid in this process.

 

Inventory financing, like accounts-receivable financing, provides a revolving line of credit. Funds are advanced to the company on the basis of a certain percentage of eligible raw material and finish-goods inventories. Advances are generally not made on work-in-process inventory because of its unfinished state and limited liquidation value. Since inventories are less "liquid" assets than accounts receivable, the amount advanced under an inventory loan is not as great as in the case of a receivables loan.

 

Amounts advanced under an inventory loan vary dramatically with the nature of the inventory, ranging from 30% to 70% of the value. On some sophisticated inventories that would be hard to dispose of, lenders may be unwilling to lend at all. Inventory loans come due as the products are sold; thus, they are often used in tandem with a receivables line of credit to provide financing until proceeds of the sale are collected. Inventory financing presents special problems for both borrower and lender. The latter must ascertain the liquidation value of the inventory and be assured that it is secured in a safe location before advancing funds. Therefore, there may be additional administrative procedures, such as monthly reports and calculation of obsolescence rates, turnover rates, and gross profit margins, to justify the borrowing base. In addition, improved procedures for controlling the inventory may have to be implemented, sometimes even to the extent of locating inventories in independent bonded warehouses, to satisfy the bank's conditions.

 

Equipment term loans provide a company with funds to purchase new equipment, or they may be used to obtain cash by borrowing against the appraised value of equipment already owned. From 60% to 80% of the equipment value may be borrowed with this kind of loan (so the company will have to make a "down payment" with its own cash). By not loaning on the entire value of the equipment, the bank improves its ability to recover its investment in case of default. These loans are generally repaid in monthly or quarterly installments over one to five years (a period that reflects the expected life of the equipment). Interest rates may be fixed or variable, depending on the bank and the credit situation of the borrower. Borrowers are often given an equipment line of credit, allowing them to purchase various pieces of equipment over an agreed-on period of time without making a separate loan agreement for each item. The borrower pays only interest until the "rollup" date, when all the borrowings are written as one term loan with one repayment schedule.

 

Equipment leasing is increasing by being used as a method of financing. Equipment leases provided by commercial banks are generally long-term rather than, short-term leases. The bank purchases the equipment needed and enters into a noncancelable agreement to lease it. The payments required may be sufficient to cover the cost of the equipment and of financing; the lease payment may even be variable and fluctuate with the prime rate. Even though the bank owns the equipment, the user, or lessee, is usually responsible for the insurance, maintenance, and any associated taxes.

 

From a tax standpoint, there are two types of full-payout lease arrangements:

 

A true lease, or "operating lease", results in the lessor (the bank) receiving any potential tax benefits of ownership-primarily accelerated depreciation. The tax benefits reduce the cost of the lease to the lessor, and a reduction usually results in lower lease payments by the lessee. The agreement often provides that the lessee will pay additional amounts if the lessor fails to obtain the tax benefit anticipated when negotiating the lease. For the arrangement to be accepted as a true lease for tax purposes, the lessee cannot be given an option to acquire the property at a bargain price at the end of the lease term; however, the lessee can obtain title to the equipment at the end of the lease period by purchasing it at its fair market value at that time. Thus, while a true lease may initially be attractive from a cost standpoint, it may be more expensive than other kinds of financing if the equipment is to be used beyond the original term of the lease.

 

 

A financing lease, or "capital lease", on the other hand, is treated as a borrowing, and the lessee is considered the owner of the equipment. A financing lease usually provides for the sale of the asset to the lessee at a nominal or prearranged price.

Regardless of the type of agreement, the advantage usually sought in equipment leasing is that 100% of the cost of the equipment can be financed. However, the bank may require you to maintain a security deposit equal to 20% to 30% of the equipment cost, which would negate this advantage. Depending on whether this deposit pays you interest and when it can be freed up, leasing may still be a more attractive alternative than a term loan. You will need to analyze the costs of all the terms when considering this form of financing.

 

Leasing can be used not only to finance equipment additions but also to generate cash from equipment already owned. In a sale-and-leaseback arrangement, the used equipment is sold to the bank at its appraised value and leased back.

 

Commercial real-estate loans, or industrial mortgages, are usually from 10 to 25 years in length and in amounts of up to 75% of the property value. These loans are comparable to mortgages on residential property. Interest rates are usually fixed, and payments are made monthly. The payments may fully amortize the loan, or there may be a balance still unpaid at the end, called a balloon payment, which must be either paid off or refinanced.

 

If the value of your real estate has appreciated since it was purchased, you can convert that into cash by obtaining a second mortgage. A "second" means just that-the lender is second in line for the collateral in case of a default; therefore, the interest rate on a second mortgage is normally higher than on a "first." As an alternative, you may refinance your entire mortgage, if current interest rates make this economically sensible.

 

Commercial term loans are often granted to businesses with strong financial histories. With this type of loan, there is no direct relationship between the amount of the loan and an individual asset of the company (unlike working-capital or equipment financing). However, the assets of the company are generally pledged as collateral. Banks monitor these loans by requiring the company to maintain certain financial ratios; if these loan covenants are not met, the bank can call the loan (require immediate repayment). Loan covenants are individually negotiated and may cover such items as working-capital levels, the current ratio (ratio of current assets to current liabilities), the debt-to-equity ratio, future profitability, and levels of equity. They may also restrict payment of dividends, additional borrowings, or capital expenditures without prior bank approval.

 

If the financial position of the company is extremely solid, the bank may be willing to make these loans on an unsecured basis (that is, with no collateral). Usually, the loan covenants will be even stricter in this case, so the bank can closely monitor the company's financial condition. Most small and growing businesses will not be in a position to obtain unsecured loans.

 

Short-term commercial loans are usually written for a period of from 30 to 90 days, primarily to meet seasonal needs, such as a buildup of inventories. These loans are expected to be liquidated once the temporary need is past. Medium- and long-term commercial loans are usually for a period of more than one but not more than ten years. The amount advanced ranges from 40% to 50% of working-capital needs, supplementing any short-term financing. Interest rates vary with the creditworthiness of the applicant, but are normally 0 to 4 percent above the prime rate.

 

Government-guaranteed loans are loans guaranteed against loss to the lender by the Small Business Administration (SBA), an agency of the federal government. The guarantee is for up to 90% of a maximum of $500,000 of loan proceeds. Because of the reduced risk of loss, the interest costs on such a loan are usually less than for a comparable commercial loan. However, you must meet specific criteria to be eligible. Normally, personal guarantees are required, and loans are on a secured basis.

 

Personal loans are often the only form of debt financing available to a startup company. They are made on the basis of the creditworthiness of the business owner and are secured by your personal assets. Because these loans are made to you as the owner of the company, you are personally liable for their repayment, regardless of the fate of the business.

 

A revolving line of credit provides your company with a committed source of money against which it may borrow as long as certain negotiated conditions are met. Like commercial term loans, a line of credit may be collateralized by a general pledge of all of the assets of the company, or it may even be unsecured. It will always involve strict loan covenants. With a revolving line of credit, the borrower may draw the funds as needed, with interest charged only on the outstanding funds. There is usually no defined repayment date, although generally the lines are expected to be repaid in full once a year for at least a thirty-day period. Banks typically charge an annual commitment fee of 0.25% to 0.50% of the unused portion of the line. Most businesses will get this financing only when they have an established track record.

 

A letter of credit is a special form of financing often used by companies dealing in foreign markets. A letter of credit is a bank-issued document, promising that the bank will pay a third party an agreed-on amount of money, provided that certain documents described in the letter of credit are properly prepared and received by the bank within a specified time period. The most common use of an "LC" is for the purchase of goods from a foreign company. Upon receiving an LC from you, a seller ships its product and can take the LC to its bank for immediate payment. Your bank, which issued the LC, may require a deposit, or it may add the balance to your outstanding loans. "Irrevocable" letters of credit are preferable to "revocable" ones, but more difficult to obtain. An irrevocable letter of credit, once accepted by the seller, cannot be altered or canceled by the buyer without the seller's consent.

 

A variation is the standby letter of credit. By putting up a standby letter of credit to support your debt to a third party, a bank guarantees payment in the event you default. Sometimes, it may be used in lieu of a performance deposit. A standby letter of credit almost always involves collateral agreements and carries with it a commitment fee of at least 1%.

 

Given the variety of loans, lending philosophies, and lending conditions, you should strive to match the most appropriate type of loan to the needs of the company. Obviously, not all banks offer all varieties of loans to all customers. The operating philosophy, resource constraints, and size of the bank must be considered when deciding where to shop for financing. The process can be aided by analyzing the types of financing available in relation to your company's economic life cycle.

 

Finance Companies and Factors

Commercial finance companies are often willing to grant loans to businesses that might not qualify for bank financing. They look primarily to the quality of the collateral instead of the track record of the company. Thus, they are often called asset-based lenders.

 

The amount advanced by a commercial finance company is determined solely by the valuation of your company's assets. The collateral for these loans is usually accounts receivables, inventory, machinery and equipment, or real estate, or some combination of these. The higher the quality of these assets, the more financing available. A finance company can often provide funds on short notice, allowing businesses to solve cash shortages without any dangerous delay. The biggest disadvantage of a commercial finance company, however, is the high interest rate associated with the loans. In many cases, this rate will significantly exceed that of a bank, often ranging upward from 4 percent over the prime rate.

 

Commercial finance companies primarily write secured loans by requiring a lien on the company's assets. The loans can be of two types:

 

Revolving loan. The finance company commits itself to an overall line of credit; the borrower draws on the line as needed and then repays. This process is repeated for a period of up to two years, until the contract is terminated. Revolving loans usually finance seasonal fluctuations in cash flow.

 

 

Term loan. The finance company grants a loan for a period of from one to fifteen years with a defined amortization schedule.

The loan process for a finance company is very similar to that of a commercial bank. It includes an analysis of the background of the borrower, an evaluation of the loan collateral, advancement of funds on the basis of a negotiated percentage, and the establishment of monitoring and pay-down procedures.

 

Factoring accounts receivable may also offer another means of obtaining needed funds. Factoring involves the outright sale of your company's accounts receivable to a third party, the factor. In this way, a business is able to obtain cash upon shipment of its products, while its customers are able to purchase under the credit terms they demand. Factoring is not a loan, since it involves the outright sale of the receivable to the factor. All collection efforts are performed by the factor.

 

Under a nonrecourse factoring arrangement, the factor assumes all the risks of bad-debt losses-if the receivable is never collected, the factor bears the loss. The factor buys the receivables at a discount from their face value to cover anticipated finance costs, collection efforts, and bad debts. In a recourse factoring arrangement, the factor will typically advance the company 50% to 80% of the receivables it buys and remit the remaining balance less fees and interest charges when the account is paid by the customer. In the event a receivable is not collectible, the company must reimburse the factor for the loss. The interest rates and fees associated with factoring are higher than those of a bank loan, making it an expensive arrangement. However, in many situations, the increased costs may be offset because the credit and collection procedures of the company can be significantly reduced or eliminated.

 

Other Sources

Several other kinds of organizations engage in commercial lending as one of their investing activities.

They include the following:  Life insurance companies. Many people think of the cash-surrender value of their life insurance policies as the only source of funds available from an insurance company. However, because the insurance companies must invest the premiums they collect, a portion of their investments is usually allocated to commercial lending. Life insurance companies write two types of loans, commercial mortgages and commercial term loans. They are usually for large amounts (minimum $500,000) and an intermediate- or long-term duration. Commercial mortgages are the principal source of financing; insurance companies generally advance up to 75% of the appraised value of the underlying property with a repayment schedule of 10 to 25 years. In some cases, a balloon payment can be arranged to minimize initial costs and monthly payments. Interest rates are comparable to those charged by banks.

Savings and loans. Savings and loan companies are chartered to make real estate loans on industrial and commercial property. During the late 1980s and early 1990s, many encountered difficulties because of questionable loans that were not repaid when the real estate industry encountered a downturn. Generally, an S&L will write a mortgage for up to 75% or 80% of the appraised value of the property, with a repayment schedule of up to 25 years. The limitations of this source of funds are that the real estate financing must be secured by a first mortgage, and S&Ls are not inclined to write loans for property that is to be used for a specialized purpose, such as a building uniquely designed for a manufacturing operation.

 

 Leasing companies. The tax advantages available to lessors have led to the organization of a number of leasing companies. Many of these are partnerships, passing the tax benefits through to their partners; others are subsidiaries of large, cash-rich corporations such as insurance companies.

  

Mutual funds. Certain large brokerage firms have formed public investment funds specifically to finance lending activities to midsize businesses.

One other method of borrowing is to sell debt securities directly to the public. These debentures are long-term obligations and are generally unsecured. This type of financing requires the use of an investment banker, who receives a commission on the sale of the debentures. The types of companies that can sell debt securities are similar to those that can sell stock in the public market. Thus, most of the considerations, advantages, and disadvantages of being a public company apply to the issuing of debt instruments.

 

 

Determining Your Financial Requirements

 If you want to start your own business, it is important to consider your financial situation. By determining your current income and expenses, you will be better at projecting your financial needs over the next months.

 For most small businesses, there is a gap between when you start your business and when you begin to produce income. In fact, most management consultants who specialize in small businesses suggest that you have at least 6 months of savings available for the start-up phase of your business. Of course, this number will vary depending on the type of business you decide to start. Service businesses and home-based businesses are a favorite choice for many women because the start-up costs are considerably lower than other businesses.

 Before you make any decisions about the type of business you would like to start, you need to develop a monthly plan of saving and spending. This will help you identify how much money you will need each month to live. Also, it will tell you if your dream of owning your own business fits with your other dreams such as sending a child to college. To develop a savings plan and spending plan:

 First, identify and write down your fixed expenses for each month for the next year. Fixed expenses include such things as insurance, home/ property, car payments, utilities, savings, etc. 

Once you have identified all of your fixed expenses for each month, total your monthly fixed expenses and annual fixed expenses. 

Next, identify your flexible expenses and write them down for each month over the next year. Since you are not obligated to specific expenses for these items, you have more flexibility in whether or not you want to include them and how much each of them will be. Consider what you've spent in previous months and any changes you wish to consider. Flexible expenses include such things as food (including dining in restaurants), clothing/ personal care, entertainment, transportation (gas), etc.  

Once you have identified all of your flexible expenses for each month, total your monthly and annual flexible expenses.

Now, subtract your total fixed expenses and total flexible expenses for each month from your expected monthly and annual income.

Is there a balance? Do you have extra money each month? If you have extra money, this is a good sign. You can use this savings and spending sheet to estimate how much you will need on a monthly basis. You can also use it to determine what will happen if your income or expenses change over the next year.

 After examining your savings and spending requirements, you may find that you lack the necessary resources to start your business. Do not worry. This happens to many people. In fact, this may be the first obstacle that you will need to overcome.

 If you are still determined to start your business, you may want to begin accumulating alternative sources of income. 75 percent of small business owners and more use their personal savings to start their businesses. However, if you need more than you have in your savings account, other money sources may be available from bank loans, family members, partners, friends, venture capital companies, mortgage property, loans from the government, or any other source that you can think of. A good rule of thumb is that you should not borrow more money than is necessary to start your business. Often, the more money you borrow, the less control you will have.

 (Women in New Development, Bemidji,MN and North Texas Women's Business Center, Dallas, TX, 4/97)

 Finance - Frequently Asked Questions

• Do I need collateral for a business loan?
• Is my personal credit history considered for a business loan?
• Is it easier for a woman to get a business loan?
• Are there grants specifically for women to start their own businesses?
• When do I have to report business income to the IRS?
• How do I file business income tax?
• Do I need an accountant?
• What is interim financing?
• If I make a sale, can I get a business loan for production?
• How should I set up an accounting system for my business?
• What is forecasting?

  

Q: Do I need collateral for a business loan? 

A: Yes. Most lending institutions want to know how the loan will be repaid in the event of default (non payment). This is particularly true for start-up businesses. Lenders want to know if the loan is fully secured.

Remember that banks are not traditional risk takers and want to know how they will be re-paid. Banks require visible assets that can be used as collateral. Banks seldom furnish start-up money. You can explore other resources as potential investors, i.e. SBA (especially the Loc-Doc, 7(a) Loan Guaranty and 504 loans), ask your banker, lawyer, Realtor, SCORE , other women business owners and Economic Development Associations. Finally, do a search on the Internet using key words for the type of start-up business you are investigating. This is particularly useful since most women entrepreneurs have little hard collateral (land, equipment and inventory) to back their loan.

 

Q: Is my personal credit history considered for a business loan?  

A: Your personal credit history is considered for a business loan because it gives the lender a history of your personal money management, demonstrates repayment of debts and it lets the lender know of existing debts including references, liens, delinquencies, bankruptcies, student loans, etc. It’s also important because if your business is a sole proprietorship or individual, there in no difference in credit history for loan purposes. However, if you business is a corporation, partnership, trade company, etc., then the lender looks at the business history.

 

Traditionally, women have secured credit through joint credit cards, loans from spouses, friends and family. If you do not have an established credit history, credit card or loan in your own name, it will be difficult to get business financing, especially in the early phases of business. Other resources to check out: debt vs. equity financing, SBA’s Borrowers Guide (an excellent quick reference to SBA loan programs), Small Business Development Centers (SBDCs), and SCORE (Service Corps of Retired Executives).

 

Q: Is it easier for a woman to get a business loan?

A: No. Even though women are the fastest growing segment of business owners, they have difficulty overcoming stereotypes. For example, some people think "women can’t do business," or "women have weak financial skills," or, even, "women are less stable than men and less established." Other challenges include establishing credibility, family issues and being unsure of how to present the business plan to a lender.

 

Q: Are there grants specifically for women to start their own businesses?

A: Yes. Research the "set asides" for women and minorities through the SBA, talk with other entrepreneurs, call the Aspen Institute (202/833-7374) for a copy of their Self Employment Learning Project Directory of Microenterprise. State and local resources include the Economic Development Agencies, microlenders and community action agencies, foundations, private corporations, credit unions and minority professionals and trade associations may be other funding options. There are often excellent resources in magazines, i.e. National Organization of Female Executives, Black Enterprise, Success, etc. Most importantly, don’t forget to ask questions!

 

Q: When do I have to report business income to the IRS?

A: The most efficient method is to call or write the IRS and ask for reporting requirements. Individuals and sole proprietors usually report income annually. Corporations and other types of businesses report income quarterly. Sole proprietors use the Schedule C, "Profit or Loss From Business" and partnerships, joint ventures, etc., sue form 1065.

 

Q: How do I file business income tax?

A: Business income tax is best filed through a Certified Public Accountant. However, a good place to start is the IRS. Ask them to send brochures on reporting and filing requirements. These publications explain the characteristics of and procedures for filing business income. Remember, an appropriate record keeping system can determine the survival or failure of a new business.

 

Q: Do I need an accountant?

A: Before initiating your business, research the benefits and challenges of several choices such as: maintaining the books yourself, hiring a bookkeeper (full or part time), hiring an accountant to set up and maintain your books. An additional option is to set up a hybrid system in which you or a bookkeeper performs the day-to-day activities, while an accountant does the period-end record preparation, summaries, reconciliations, payroll taxes, excise taxes and the returns for sales taxes (if applicable).

 

There are many types of professionals to consider: CPAs (individuals who have passed a national accounting examination), Enrolled Agents (individuals who have passed an IRS exam covering many areas of federal taxation) and Accredited Accountants (individuals who have passed a rigorous exam by the Accreditation Council of Accountancy and Taxation. Accredited accountants specialize in small business accounting.

 

Q: What is interim financing?

A: Interim financing is short-term financing obtained for business purposes only until another source of long-term funding comes in. An example is a short-term construction loan to build a warehouse. When the building is complete, a long-term commercial mortgage is used to pay off the construction loan. The mortgage, similar to a home mortgage, is paid back over a number of years.

 

Q: Can I get a business loan if my business is service-based?

A: Yes, typically it is not the type of business that matters, but rather the creditworthiness of the guarantors, the financial performance of the business and the collateral pledged. The real issue is that often service-based businesses have very few hard assets (like inventory, equipment or accounts receivable) to pledge as collateral, but banks and the SBA require some form of collateral. Consequently, business owners often pledge personal assets to obtain a loan. (A common misconception of many people is that this personal asset must be a second mortgage on your house—not true!)

 

Q: If I make a sale, can I get a business loan for production?

A: Yes, many banks provide short-term financing for production. (It’s important to keep in mind that often loan applications can take up to a month or more and timing may be an issue if you have already accepted an order from a client.) Production financing is typically done under a line of credit for established businesses. Loans to start ups are always term loans payable over several years. You and your business need to qualify for the loan. Your personal financial situation will be reviewed, as well as your credit history. The business will be analyzed for cash flow, profitability, and collateral. 

 

Q: How should I set up an accounting system for my business?

A: If you want to set up the system on your own, browse through our Finance Center for MANY helpful articles.

You might, however, consider having an accountant set up your accounting system. For tips on choosing an accountant, read How do I select an accountant? and other related articles under the section entitled "When You Require Assistance…" in our Finance Center.

 

Q: What is forecasting?

A: Forecasting is a projection of the anticipated financial performance of the company. Forecasts typically include a projected income statement, a cash flow statement and a pro-forma balance sheet. In order to arrive at projected figures, extensive research should be done to including statistical information on the competition, client demographics and product trends. This information will help you obtain reasonable sales figures. One should also get quotes from suppliers and realtors to obtain estimated expense figures. Projections are not pie-in-the-sky figures or a scenario of what you would like to see happening to your company, but rather carefully calculated, realistic numbers.