The unknown unknowns of business (Part 2)

Securing a business loan can be an intimidating process. Success is not guaranteed, and a misstep can be costly. If you are not familiar with how lenders think, the process can be especially perilous. It can be hard to know what questions to ask and what decisions to make. We created this series to help business owners position themselves for success.

Lewis is a persona we introduced in Part 1 of the series when he was starting his corporation. He is now 40 months into operations of a construction company. His Company is growing, but he turned down a new project recently because he does not have the equipment needed to complete it. Lewis is familiar with the equipment, and he wants to complete projects like this in the future. The equipment is highly specialized, and it is not available for lease. These types of projects are profitable and require more cash to support operations, so Lewis wants to obtain a loan to purchase the equipment and support the growth of his business. Lewis takes the first step in securing a loan by asking his business advisor what he needs to do.

How do I estimate the risk of the loan?

Lewis’s business advisor suggests that he start by researching the cost of the equipment. Lewis has identified two different models he would purchase. One model costs $200,000, has an estimated useful life of 5 years and has annual maintenance expenses of $35,000 per year. The other model is $450,000, has an estimated useful life of 10 years and comes with annual maintenance expenses of $20,000 per year. Lewis’s advisor suggests they calculate the future cashflows generated from the equipment based on high and low estimates of gross profit from the new business segment.

Lewis estimates he will be able to generate between $90,000 and $120,000 in gross profit each year he owns the equipment less the annual maintenance, interest and tax expenses. Lewis’s advisor explains that if he can secure a low-interest rate loan (below 2-3%) and make a higher gross profit, then the more expensive option is more profitable, but if the interest rate is 5%-10% and his business does not perform then he could lose a lot of money on the investment.

Lewis’s advisor explains that the profitability of the investment is dependent on the interest rate, and that the higher the risk of the investment the higher the interest rate. The risk of the loan lies in whether it can be repaid, and generally the degree of uncertainty dictates the interest rate and whether a loan can be obtained.

Is my business ready for a loan?

Lenders will consider all angles of a business, not just the specifics of the loans purpose. Lewis’s business advisor tells him that lenders will look at his business objectively and make lending decisions primarily based on their overall and specific business risk assessments, the industry and the larger economy. Lewis’s advisor suggests he complete a risk assessment of his overall business to help support his loan application.

This includes reviewing the business’s overall financial performance. Lewis’s advisor cautions him that his current year-to-date financial statement may hurt his application.

Lenders compare ratios and line items on the financial statements with industry standards to evaluation a business’s financial performance. To see how his business compares to industry benchmarks he can seek out industry reports, including ones provided by the Government of Canada. This link is a good starting place.

Lewis’s business advisor noticed that Lewis’s Accounts Receivable (Link) ratio is low, which indicates that he is collecting payment from his customers slower than he should be. This can be a red flag for a lender, and it may be an indication that some revenue is not collectable. The uncertainty of collection increases the risk of his business. Lewis’s advisor recommends he lower his AR ratio by scheduling time once a week to call his customers that have not paid him yet.

After project expenses, the gross profit of the business is also less than ideal. This could be an indicator that the Company has operational issues, fierce competition, unpredictable project costs, etc. all of which increase risk. Lewis is not sure what the reason for the low profit margin, so he decides he will spend more time with his lead project manager to assess and correct any operational efficiencies.

Do I need collateral?

Lenders generally lend on collateral, which can be seized by the lender in the event of a default. Lewis can mitigate the risk of the loan by securing the loan with collateral. This can come in many forms including: a personal guarantee on Lewis’s family home, multi-year customer contracts or showing that the equipment could be resold at a price that would cover any remaining loan principal.

Lewis speaks to several of his potential customers, and they are willing to write letters of intent to support his loan application. The letters indicate a willingness to work with Lewis for the first 14-months of the loan. Lewis also researches the resale price of similar used models. His equipment is highly specialized, and he is not able to find many examples, but he finds one recent sale of the $200,000 model that sold for $85,000 after 3 years of use.

Lewis now has a plan to de-risk his business. After considering the research and the cashflow projections, Lewis decides that he will attempt to purchase the $200,000 model if he can secure a 5-year loan with an interest rate of 5% or less. The next step is to find the right lender and walk them through the reason for the loan, the risks of the loan and what Lewis is willing to do to mitigate those risks. With any luck, knowing Lewis has a specific purpose for the loan and has taken meaningful steps to de-risk it will go a long way with potential lenders.

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