Whether you operate a brand-new start-up or a business that’s been in existence for many years, if you need financing, banks and other financial institutions will require some standard information before cutting you a cheque. All too often, entrepreneurs are caught off guard when asked to provide this documentation.
The type of credit you need–such as working capital for the business, a loan for equipment or real estate financing–will dictate the terms and security. For the purpose of this article, let’s take the example of a fictional entrepreneur widget manufacturer looking to finance working capital and equipment for his growing business.
Joe Widget is the owner of Widget Inc. and has found a new market for his newly developed widget products. He expects to triple his sales over the next three years. His business has been financed with personal funds and a small home equity loan, but he now requires $1,000,000 to finance working capital (receivables and inventory) and $500,000 to spend on new equipment.
At the very least, many lenders will want to see a three-year history of earnings and cash flow, with a current interim financial report and perhaps a financial projection for the business over the next year or two. The lender will likely insist that the prior financial statements be reviewed by a Chartered Professional Accounting firm, or at the very least that an accounting firm that has issued a Notice to Reader Statement–which is when an accountant offers no assurance on the financial statements.
If your financial statements have been internally prepared over the past three years, you’d be well advised to speak to a CPA firm before your meeting with the bank to find out the time and cost involved in having them either issue their review-engagement report or notice to reader on your prior-year financials.
Banks and other financial institutions will need to assess the available collateral to secure the loan, personal character and personal net worth of the owner, personal and corporate tax returns, and notices of assessment.
The lending institution will look at your company’s and your personal credit history as part of their due diligence process. You might want to obtain a personal and corporate credit report beforehand and correct any errors before you submit that loan application.
Lenders will always ask for collateral to secure the loan to minimize the risk of extending credit. In the case of Widget Inc.’s at least $1,000,000 in working capital loan needs, the bank would be asking for security on the company’s accounts receivables and inventory. The conventional standard is to lend up to 75 per cent of a corporation’s receivables under 90 days and usually no greater than 50 per cent of inventory. In our case, Widget Inc.’s receivables are $750,000, of which $650,000 is under 90 days with inventory of $950,000, so these amounts would present enough coverage for the necessary loan amount.
As an ongoing condition to keep the loan in good standing, the bank would usually insist on a monthly aged accounts receivable listing, and an inventory listing at least once a year, perhaps even more often. That brings up another important point: the business should have a competent in-house bookkeeper or accountant, as well as a reliable accounting program that can generate the necessary financial information.
Now, because working capital loans are generally revolving, they can fluctuate daily up to the maximum of the loan. They are usually interest only, due on demand and the interest rate is often variable and pegged to the bank’s prime lending rate plus between 1 per cent and 5 per cent, depending on the level of risk.
For our equipment loan of $500,000, the bank would be attaching security directly on the equipment. These loans are repayable on principal and interest, usually over a period of between three and five years.
In almost all situations except in the case of the most creditworthy circumstances, banks will insist on personal guarantees. The purpose of this is in the event the company goes into default and the bank calls the loan, to the extent the bank cannot realize on the corporate security, they will go after the shareholder(s) personally for any shortfall.
Other stipulations from the bank as a condition for providing credit could include a postponement of shareholder loans, limits on the payment of dividends, prior approval for the purchase of additional equipment or cross defaults from related companies.
Once the loan is in place the lender will perform its annual year-end review. Banks will usually insist on annual financial statements with either a review engagement report or notice to reader from a chartered professional accounting firm within 120 days after the year end. The banking agreement will stipulate the financial covenants the corporation needs to have maintained at year end. These covenants can include any one (or all) of key figures such as the business’ working capital ratio, total debt to tangible net worth or debt service coverage. A competent CPA will be aware of these financial covenants and should be monitoring them with you throughout the year to ensure there are no breaches, and then working with you to correct them (or to provide explanations for breaches that could not be corrected) before the financial statements are finalized and issued to the company’s bankers. Where loan breaches exist at year end, they must be disclosed in the notes to the financial statements.
It’s clear that applying for a loan is complicated and requires the advice and counsel of several professional advisors prior to signing on the dotted line. That includes the services of an experienced corporate lawyer who will review the documentation from a legal perspective to ensure there are no surprises. And as I’ve mentioned throughout, you need to rely on the expertise of your CPA to review the financial terms of the offer to finance and to monitor the ongoing financial health of the company once the financing is in place. The goal is to avoid that dreaded call from the bank informing you that, “Your business loan is in default!”
Hartley Cohen, Partner