Small business owners often don’t have the cash on hand for expansion, equipment upgrades, or even unexpected emergencies, so having access to outside funding is an essential part of your business’s success.
There are many creative ways for businesses to raise funds, but most business owners take the traditional financing route and apply for business loans or seek out investor backing.
Also known as debt financing and equity financing, both approaches are excellent ways to raise funds, but it’s important to know the implications of each.
Debt financing is when a business owner borrows money from a bank or other lending institution. Borrowers must qualify for these loans, and the money is paid back over time with interest.
With equity financing, the business owner receives money from an investor that does not need to be paid back. However, in exchange for the funding, the investor assumes partial ownership of the business and receives a percentage of the equity.
Many business owners don’t want to give up full control of their company—or its equity—so they apply for loans or lines of credit from banks or other lenders.
Establishing strong business credit is essential for small businesses that need to borrow money to build or grow their companies. Lenders want to know you are willing and able to repay debt before they approve your credit application.
Because you never know when you will need to seek out funding, it’s important to manage your business’s financial obligations well from day one. Establishing and maintaining good business credit is far easier than rebuilding damaged credit.
Some startup owners use their personal credit to borrow money for their business because they haven’t established business credit yet. However, it’s much safer to keep your business and personal credit separate if you are able.
For example, business credit has tax requirements that personal credit does not, which can complicate filing at tax time and even result in penalties. Also, there are differences between personal and business credit reporting that can have an impact on your credit score and borrowing potential.
By law, if a credit bureau makes a mistake on your personal credit report, you can challenge the mistake, and the bureau must respond. Business credit reports don’t have the same protection, so mistakes are difficult to resolve.
We recommend regularly checking your credit reports with the three main business credit bureaus—Dun & Bradstreet, Experian, and Equifax—so you can catch problems or mistakes early.
Your personal credit follows you around for the rest of your life. However, your business credit belongs to the business. If you decide to sell the business, the new owner will inherit the credit history, so a clean credit report will increase the value of the company.
Nonmortgage personal loans rarely exceed the $20,000-$30,000 range. Business loans, however, can reach millions of dollars. Establishing good business credit will help maximize your borrowing potential.
Small business owners have three main types of credit available, each of which can be used to serve a different purpose. They are:
Commercial credit cards provide access to short-term capital that can be used to improve cash flow, streamline spending, cover emergencies, and build your business credit.
A business line of credit (LOC) is similar in function to a credit card but with a higher credit limit. An LOC can be used for purchases, such as supplies and inventory; expenses that can’t be put on a credit card, such as payroll; and funds to keep the business running during slow periods.
Business loans provide a lump sum of money that can be used for major purchases or for growing your business. Unlike credit cards and lines of credit, loans are paid back over time with interest on the full amount.
Most small businesses use one or more of these credit options to keep their companies growing, manage employee spending, and build a solid credit profile.
Creditworthiness can make or break a business. And just like with your personal credit, there are several factors that influence whether or not you will qualify to borrow money or open a line of credit when you need it.
Here are six things lenders look at when you submit a credit application:
Lenders will consider both your personal and your business credit health when you apply for a business loan, line of credit, or credit card.
Your credit score and credit history are two of the biggest factors that determine whether you will be approved because they are strong indicators of your willingness and ability to repay debt.
Lenders will look at how many open lines of credit you have as well as any outstanding credit applications because these can affect your ability to make payments as required.
Many lenders require collateral for business loans to help protect their investment. This can include real estate, stocks, machinery, inventory, office equipment, or any other valuable company assets that could be sold to repay the loan if you default.
If the lender accepts your collateral, they will determine the loan-to-value ratio for your assets. Generally, your business loan amount will be between 70-90 percent of the collateral value.
Most lenders want to see your business plan before they agree to lend you money. This document doesn’t need to delve too deeply into the minutiae of the company, but it should include information about market potential, competition, and company structure.
A well-written business plan will show potential lenders that you have done your due diligence, which reduces your perceived risk level and improves the odds that your application will be approved.
Lenders want proof that you are able to repay a loan or make on-time payments on credit lines, so they will take a deep dive into your company’s financials. This process may include a review of capital investments in the company, which is a good indicator that you are committed to the business’s success.
Be prepared to provide financial documentation, including your most recent profit and loss statement, cash flow statement, bank account balances, asset inventory, and investment documents.
Cash flow is going to be one of the biggest determining factors in the loan application process. It’s important for lenders to see positive cash flow or that there is more money coming into the business than there is going out of it.
Lenders will also calculate your business’s debt-to-income ratio to confirm that there is enough money left over after all the business’s monthly bills are paid to comfortably make a loan payment.
Excellent trade references can have a major positive impact on your loan application. Trade references show lenders that you consistently make payments on time to other businesses and suppliers. This helps reassure lenders that you are unlikely to default on your business loan.
Whether your business is just getting off the ground or you are looking to cover new ground, at some point, you will need access to funding. Establishing good business credit early on will help ensure you have funds available for growth and expansion, new equipment, software upgrades, and unexpected emergency expenses.
To maintain your business credit health, be sure to monitor credit scores; understand the terms of your business loans, lines of credit, and credit cards; and build good financial relationships with your vendors, suppliers, and other stakeholders.
At First State Community Bank, we understand how important funding is to small business success. Download your free copy of our guide, How to Choose the Right Bank for Your Small Business, to learn why partnering with the right financial institution will help your business thrive.