How a bank looks at your business

Financing is a key part of running a successful business: It allows you to invest, to purchase inventory, to manage your cash flow and even perhaps to acquire a competitor, to name only a few ways you could use a loan.

However, banks are also businesses. They need to be careful and diligent about lending only to businesses that are likely to repay in full and on time.

To make sure you maximize your chances of getting a business loan, it is important to understand how banks look at your business.

What factors do banks consider before lending money?

When reviewing a loan application, banks and financial institutions will generally analyze four main factors.

1. The financial strength of your business

To make sure your company is on a solid financial footing, your bank will want to have a look at your financial statements, says Christopher Daigle, Account Manager, Small Business, BDC.

“This means looking at your results for the last couple of years, and comparing them to industry averages,” says Daigle.

A rule of thumb is that your borrowing capacity is guided by your net income plus depreciation, less the annual amount of repayments of existing term debt. Basically, any profit you are earning is available to cover new debt service.

2. Assets

Banks will also be evaluating your assets, both as an indicator of your company’s strength, but also in order to identify collaterals that can be pledged as a security for the loan.

In the fishing industry, for example, a bank would likely want to know whether you own boats, gear, trucks, traps, and intangible assets like licences.

“A bank may be willing to take your crab or lobster licence as a security because they hold significant value. In Lobster Fishing Area 36 or 38 which is part of the Bay of Fundy, for example, a lobster licence can’t be had for less than $1 million,” explains Daigle.

3. Your management credibility

You’ll want to demonstrate that you have the skills and experience necessary to successfully run your business. Highlight how your background has prepared you well to manage your project and bring it to fruition.

It’s also a good idea to surround yourself with professionals who can help you benefit from their experience.

“Banks will also look at who is advising entrepreneurs, whether it be accountants or other experts,” says Daigle.

4. Credit score

Your personal and business credit scores are important factors a banker will consider when you apply for a business loan.

Your business credit score is separate from your personal score. Your business credit score includes reports from firms that do business with your company, such as suppliers and financial institutions. Meanwhile, your personal score is based on your past personal credit behaviour, such as whether you pay your bills on time.

Besides meeting your payment due dates, you can keep your credit score healthy in other ways. Make sure you only apply for the credit you need and avoid opening multiple credit accounts. It’s also important to separate your business credit from your personal credit—use business loans, your business line of credit and business credit cards for business purposes only (i.e., to finance investments, purchase supplies and top up working capital).

Finally, know that a poor credit score may make it more difficult to obtain financing, but will not make it impossible: there are a number of strategies you can employ to obtain a loan when you have a bad credit score.

5. Your industry’s health

The strength of your industry is one indicator that helps determine how well a business will do.

“In fisheries, for example, banks would look at catches first. Are they up or down? They would then look at prices. Where are they heading? In the

end, your bank wants to be paid back, then this is an important factor,” says Daigle.

What do financial institutions look for in firms?

In assessing whether to finance a small or medium business, financial institutions look for a number of green flags. The three most important will be the following.

1. Strong cash flow

Having a strong cash flow is the first green light lenders will be looking for.

“Is the business generating enough cash flow to pay the debt? This is definitely the most important indicator,” says Daigle. “Cash is king.”

2. Small amount of debt

Having too much debt can crush a business, but being too debt averse can get in the way of running a business efficiently, as loans can be an appropriate tool to manage and preserve cash flow.

All in all, banks will look at your level of debt, and whether it is in line with your industry.

3. Business owners with skin in the game

Finally, banks also like to see that entrepreneurs are investing their own money in the company. It is an indicator that they have skin in the game, and that they are sharing the risk.

“If a business runs 100% on loans, it looks like the owners are not committed to the business. But, if they are investing themselves, the relationship with the bank is mutually beneficial,” says Daigle. “It becomes a partnership.”

What ratios do banks look at for business loans?

Whatever your industry, lenders will look at two financial ratios.

Debt-to-equity ratio: The debt-to-equity ratio is calculated by dividing a company’s total debt by the total equity of its shareholders. It shows how much debt a company has compared to its assets, and measures both a company’s ability to service its current debt payments as well as its ability to raise cash through new debt, if necessary.

Debt-service coverage ratio: The debt-service coverage ratio equals adjusted EBITDA (less current income taxes, distributions paid and unfunded capital expenditures incurred during the period) divided by the sum of current portion of term debt (how much principal is due in the next fiscal year) and interest expenses. It is a key measure of a company’s ability to repay its loans.

Depending on your line of business, a bank may also look at other industry-specific ratios.

“In the hotel business, for example, banks will want to calculate your occupancy ratio, and perhaps perform sensitivity analysis to determine how a change in this metric would affect your financial performance,” explains Daigle. “What if your occupancy goes down by 5%, can you still repay the debt?”

Do lenders look at spending habits?

When trying to determine whether they will make a loan to your business, financial institutions will be scrutinizing your company’s spending history.

Is your spending in line with industry standards? A fishing company, for example, probably only needs one truck, not five or six, says Daigle. “Business is conducted on the wharf, where the buyers will usually come pick up your catch,” he says. “It’s a good sign when entrepreneurs are responsible with their spending, and business owners should know and understand that a bank might ask them to explain or justify certain spending decisions.”

What can a lender see?

When reviewing your company’s loan application, a bank will be able to look at all the documents it has asked you to provide.

Those documents will most likely include your business’ financial statements as well as your personal credit report, since business owners’ personal credit habits are a good indication of the way they handle their business credit. “A bank may also ask for documents supporting your ability to reinvest in the company, such as bank statements or investment statements,” explains Daigle.

A financial institution will also be likely to ask for licences, if they are required in your industry, as well as quotes and purchase agreements if you are using the loan to acquire a piece of equipment or contract a service.

How does a bank decide how much to lend?

Lending ability is dictated first by cash flow.

Because banks are looking to reduce risk, they do not want to give a company more than it can handle. Their main focus will be analyzing how much money the business makes, and consequently, how much it can safely afford to borrow as well as specific financial ratios.

Banks will also consider whether your loan will help your business improve its revenue and profitability, thus increasing the odds that the loan will be repaid.

“If a fisherman uses a loan to get a bigger boat, this new vessel may be used to increase the lobster catch from 10,000 pounds to 15,000 pounds, which goes right to the bottom line,” says Daigle.

“At the end of the day, these are the main factors: credit score, solid cash flow, impact of the lending project on the company’s finances, and healthy financial ratios.”

Next step

Get more insights into what lenders and banks look for when evaluating you for a business loan in this free guide for entrepreneurs: How to Get a Business Loan.