Determining Your Credit Worthiness For a SBA 504 Loan

This SBA 504 Loan video describes the guidelines for credit worthiness when applying for small business loans through the SBA 504 financing program. For easy reference, see the full transcript below the video.

Now that we’ve talked about the issues related to working with the right bank and CDC partners, we’ll move on to discuss the primary factors that will be considered in determining your business’s creditworthiness. Your business’s ability to safely make the SBA loan payments due over the length of the loans will be evaluated by both the bank and CDC. If both the bank and CDC approve your loans, the SBA will make a final review of your eligibility for the SBA programs. Their review is generally limited to eligibility requirements and they will likely not engage in further credit analysis. Tenure. One of the main considerations of business credit is length of time in business. The statistics show that over 50% of small businesses fail in the first five years. Businesses with longer tenure are simply less likely to fail making this a simple but effective component of business credit analysis. Cash Flow & Debt Service Coverage. Probably one of, if not the most important factors in determining a business’s creditworthiness is its ability to generate consistent, positive cash flow. When assessing whether a business will be able to make the required loan payments, banks and CDCs will calculate what’s commonly referred to as a “debt service coverage ratio.” There are a number of variations but they all aim to measure the ratio between the amount of cash profit a business has or is expected to generate and the business’s total loan payments. Typically, SBA 504 lenders will want to see a ratio of at least 1.25:1.00, meaning for every dollar of loan payments due, the business earned at least $1.25 with which to cover it with some cushion. To say it another way, if, for example, business A’s total loan payments for the year amounted to $100,000, they would have needed to produce at least $125,000 in cash profit during that same period, to be at or above the minimum ratio. A common litmus test is to add the loan payments required for the new loans being requested to the business’s existing loan payments and compare that number to the amount of cash profit generated during the business’s last fiscal year. If a business can show they would have been capable, the prior fiscal year, of making all their required loan payments - with the new debt included- and have some cash to spare, they stand a great chance of being approved for a loan through the SBA loan programs. If this can’t be shown, the credit analyst will be relying on a projection of future, increased earnings which is considered a much riskier loan. While the debt service coverage ratio test does not automatically approve the loan request, it will usually result in a decline if the ratio is not high enough and plays a huge role in new business financing. Leverage. Another very important element of business credit analysis of small business lending is the amount of debt owed compared to the amount of equity or net worth maintained by the business. Commonly referred to as “leverage,” banks and CDCs will look to this ratio as a considerable piece of the overall analysis. Though there will be more fluctuation between underwriters on what they consider acceptable levels of debt, they will all have a certain comfort level they prefer to stay within. A fairly common level credit approvers like to stay under is 3:1, meaning the business’s total debt does not exceed 3 times the business’s equity or net worth. Generally, a business will be allowed to exceed preferred leverage ratios if they can show consistently strong cash flow. Financial condition of personal guarantors. As we mentioned earlier, small business owners will normally be required to personally guarantee loans to the business. As such, the financial condition of the personal guarantors will be evaluated in the decision process. Guarantors with substantial levels of liquid assets and/or equity in other assets that can be pledged to the loan as additional collateral are preferred. Personal credit scores will also be reviewed. Keep in mind that business owners will need to pass a personal liquidity test for their business to be eligible for the SBA 504 program. Owners with high levels of cash or cash equivalents are deemed to not be in need of SBA assistance and are therefore not eligible. Business plan. The final major component of business credit analysis I’ll mention is the business plan. The importance of this is much greater for a business applicant that is not able to demonstrate or prove its ability to cover all its required debt payments (with the requested debt included) from historical cash flow. As we discussed earlier, in this scenario the lender will be relying on the business to increase profitability from existing levels. The bank and CDC will need to believe that the business’s plan for doing so is feasible and has a good chance to be successful. Factors such as market competition, management experience, and the expenses required to generate and support the increased profits, are some of the main considerations. To summarize, the bank and CDC need to be comfortable that management is sufficiently knowledgeable, has a sound plan to produce the level of profits needed, and is competent to do so.