[FAQ about Financing for Small Businesses]

What are SBA loans and how are they different from conventional business loans?

A: The Small Business Administration is not a direct lender. Rather, the SBA offers financing through lending intermediaries--i.e., conventional lending institutions that make loans that are guaranteed by the SBA. SBA loans are targeted to businesses that have unique financing needs not met by conventional business loans.

The general types of SBA loans are: 7(a), 504 and SBA Express...

> 7(a) loans are for working capital, inventory, purchase of equipment, business acquisition, start-ups and other expansion needs. The loan term is anywhere from 5 to 25 years contingent on the amount and use of the loan. The loan size ranges from $5,000 to $2,000,000. The interest rate is based on prime plus a spread that is adjusted quarterly. This loan has no prepayment penalty. To be eligible, a business must be either in retail, professional or services industries with annual revenues under $25 million; manufacturer, wholesaler and distribution industries annual sales requirement depends on industry. Collateral pledged are typically business assets, and perhaps personal assets. The fees involved are: $250 to $1,000 processing fee; normal closing costs that vary with loan size.

> 504 loans are for acquisition, construction or renovation of owner-occupied commercial real estate and capital equipment. The loan term ranges anywhere from 10 to 25 years depending on the amount and use of the loan. The loan size ranges from $250,000 to $10,000,000. The interest rate is fixed or variable based on market rates. To be eligible, the project must be 51% owner-occupied, net income of less than $2 million, business tangible net worth of less than $6 million. Collateral pledged are assets to be acquired and owners with more than a 20% share must provide a personal guarantee. The fees involved are: 1 to 2 percentage points + normal closing fees.

> SBA Express loans are for working capital, inventory, equipment and real estate expansion. The loan term ranges from 3-year revolving line of credit, converting to a 4-year term loan or a 7-year term loan. The loan size goes up to $150,000. The interest rate does not exceed 4.75% over the prime lending rate. Same eligibility requirements as a 7(a). Collateral is same as 7(a), but processing fee is $250.

What is meant by the 5 C's of Credit?

A: Private sector banks are in business to maximize value for its shareholders.
Consequently, when a bank lends money, it attempts to lend money to those applicants that are deemed as the best credit risks from the applicant pool. The bank assesses credit risk based on the 5 "C's" of Credit:

> Capacity to repay is the most significant of the five factors. The lender will have to determine the sources of income that the applicant possesses to repay the loan. The main consideration will be cash flow generated from the business. The lender will also consider contingency sources of income--i.e., marketable securities, money market accounts and other assets that can be quickly liquidated into cash.

> Capital is the money that has been invested by the business owner into his/her business. The amount of invested capital by the owner is indicative of the owner's stake and confidence in the viability of his/her business.

> Collateral is pledged assets to guarantee the security of a loan. Collateral is deemed as a second source of income in the event that the borrower cannot repay the loan. Assets that are typically accepted as collateral are fixed assets of a business--i.e., equipment, plant and property. Banks typically will file a UCC (Uniform Commercial Code) lien on collateralized assets. Banks also consider working capital--accounts receivable and inventory--to be feasible sources of collateral. But, typically banks will usually discount the value of working capital (being that the market value is neither fixed nor certain) at 70% of estimated market value.

> Conditions focus on the intended purpose of the loan. How will the proceeds from the loan be utilized--to purchase equipment, working capital? Will the use of the loan contribute to the future economic growth of the business? Also banks consider the local market and economic conditions both within your industry and other industries that affect your business--e.g., your suppliers and customers.

> Character is the personal impression that a prospective borrower makes to a potential lender or investor. This is the more subjective of the five credit factors. A person's educational background, industrial experience and credit history with other creditors will be considered.

Who are the credit reporting agencies?

A: There are 3 credit reporting agencies: Experian (formerly TRW), Equifax and TransUnion. All three generally have the same format and approach to reporting one's credit. These agencies update consumer records on a monthly basis; however, often times credit reports contain errors or may be out of date--e.g., an account that may have been closed 12 months ago may still show that it is open. One of the first steps to getting a loan is checking the accuracy of your credit reports. To contact the credit reporting agencies:

> Equifax: P.O. Box 740241/Atlanta, GA 30374-0241/1-800-685-1111/www.econsumer.equifax.com

> Experian (formerly TRW): National Consumer Assistance Center/P.O. Box 200/Allen, TX 75013/1-888-397-3742/www.experian.com/consumer

>Trans Union, LLC: Consumer Disclosure Center/P.O. Box 390/Chester, PA 19022/1-800-888-4213/www.transunion.com

I am a minority/women and I want to start and/or grow a business, what financial resources are available to me?

A: There are basically three (3) types of financing vehicles available to minority/women-owned and operated businesses--grant capital, debt financing and equity financing.

> Grant Capital: Although rare, there do exit some programs that provide grants (external-injected capital into a business that does not have to be repaid or have return-on-investment conditions) that specifically target minority/women businesses. These programs are typically administered by private non-profit organizations, foundations as well as government programs. These grants typically are small in sum and have limited application requirements: a compelling business plan, minority status on the part of the applicant, small business status (usually defined by number of employees and annual revenue). Most programs offer grant capital from $500 to $30,000. The application fee for grants typically ranges from $0 to $25 (contingent on the grant-offering organization). Because grant capital is the most cost-effective means of starting or growing a business, competition for such grants can be extremely keen. One foundation in particular only offers 11 grants per year out of several hundred applications. For more information on grant capital, contact Gladys Hurtado

> Debt Financing: Commercial banks have aggressively targeted minority/women businesses by offering streamlined application processes to encourage loan volume among such businesses. Most programs have maximum loan amounts between $100,000 to $500,000 (loans greater than these amounts typically have to undergo normal application procedures). The interest rate and fees associated with the loans usually are the same as conventional loans as well as the underwriting guidelines of the lending institution. Moreover, due to CRA (Community Reinvestment Act) requirements, lending institutions are legally required to appropriate a certain percentage of its active assets (lending portfolio) to under-served communities. This encourages banks to actively target minority communities. [ Also see SBA Loans above.]

> Equity Financing: The prevalence of equity financing is much more sparse than that of debt financing for small businesses. The equity markets, unlike the debt markets, are not regulated in the sense of investment requirements into under-served communities. Consequently, equity financing--e.g., venture capital--is not nearly as ubiquitous as small business loans. Although equity capital is not ordained under CRA requirements, federal agencies such as the MBDA (Minority Business Development Agency) of the U.S. Department of Commerce have established steering committees to address bringing venture and equity capital to the minority business sector. Moreover, the SBA has an SBIC (Small Business Investment Company) license program in which the SBA partners with equity investors to inject equity capital targeted toward small businesses. Equity financing is distinct from debt financing in the sense that equity financing does not have to be repaid; but rather, the investor anticipates a return on investment in the form of profit sharing and also joint governance of the strategic decision-making of the business. In addition, equity investors look for companies that show potential for aggressive sales and margin growth. Consequently, equity investors usually target companies that operate in industries that are in a growth stage (e.g., bio-technology, telecommunications firms) versus those that operate in mature markets (retail, professional services).

What are the required documents to get a business loan?

A: The type of financials that are required is contingent on the type of loan for which a business is applying as well as the type of business that is applying. Generally, start-up companies and established companies will have the following required documentation:

>Start-Up (less than 2 - 3 years):

>Established Business (more than 2 - 3 years):

What are some of the basic financial ratios that banks analyze?

A: Every bank has its own ad hoc method of credit analysis. But the common forms of financial analysis are the examination of debt ratios, liquidity ratios, activity ratios and a breakeven analysis.

> Debt Ratios indicate how "leveraged" or how much debt a business has on its capital structure. Capital structure is all the sources of funding for a business--debt, equity and mezzanine capital (near equity financing). The most common debt ratios are shown below:

Debt/Equity ………… the amount of debt for every $ of equity

Debt/Total Assets…………the amount of debt as % of capital (capital = assets)

> Liquidity Ratios indicate the business's ability to service its debt with its existing or projected internal operating cash flows. These ratios are used not only in determining whether a business has the capacity to service additional debt, but also the appropriate amount of which the loan should be approved. The most common liquidity ratios are show below, known as "interest or payment coverage ratios":

Free Cash Flow/Interest-Only Payment ……the amount of free cash flow for every $ of interest payment.

Free Cash Flow/Loan Payment……the amount of free cash flow for every $ of monthly payment.

> Activity/Turnover Ratios indicate how quickly working capital or current assets--accounts receivable and inventory--are converting into cash (CASH IS KING!). Bankers are not concerned as much with company profits as they are with free cash flow. Many bankrupt companies can show profitability, but nonetheless be illiquid. The ratios shown below are known as "receivable turnover and inventory turnover ratios", respectively.

1/(Credit Sales/Accounts Receivable)……..frequency of converting credit sales into cash

1/(Cost of Goods Sold/Inventory) …….. frequency of converting inventory into a sale

Many small business owners try to impress bankers by inflating their balance sheets by having high A/R and inventory. However, this lowers your activity ratios, which signifies that either your accounts receivable are turning over slowly (i.e., your customers are not paying you within 30 days) or your inventory is sitting on the shelves because no one is buying it).

> Breakeven Analysis is designed to convey how many units of one's product/service must be sold to cover total costs (total variable costs + total fixed costs). The breakeven point can be conveyed in units or dollars.

In Units: Fixed Costs/Contribution Margin.......Contribution margin (sales price per unit - variable cost per unit)

Example: A business owner's total monthly fixed costs are: rent $3,000; utilities $800; administrative salaries $7,000; insurance $1,200. Assuming that the business sells widgets at $5 per unit and the variable cost per unit is $2.75... the unit breakeven point would be ($3,000+$800+$7,000+$1,200)/($5 - $2.75) = 5,333. The business would have to sell 5,333 widgets just to cover its total costs.

In Dollars: {Fixed Costs/[ 1 - (Cost of Goods Sold/Sales)]}......Cost of goods sold (variable costs) are direct costs of labor and material.

Same Example as above: The dollar breakeven point would be {$12,000/[1 - ($2.75)/$5.00)] }= $26,667. The business would have to generate $26,667 in monthly sales to cover its total costs.

A breakeven analysis is very instrumental in determining the amount of overhead (fixed costs) that a business can afford to cover with sales volume.