Understanding the Basics of Credit
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Dawn Fotopulos is associate professor of business at King’s College. A “recovering banker” with more than 20 years’ experience working in business, Dawn is an expert in entrepreneurship and has guided hundreds of struggling small businesses to recovery. She is also the author of Accounting for the Numberphobic: A Survival Guide for Small Business Owners.
Credit: A Definition for the Rest of Us
When we talk about credit, we’re talking about a loan – a loan that has to be paid back with interest. The lender is taking on risk to lend your business money. He or she needs to have confidence that your business has the reputation and cash flow to pay back the loan on time with interest. The interests you pay is compensation for that risk.
Your interest expense decreases your profitability and your cash flow, but it may be worth taking out a loan if the loan proceeds will help you do some or all of the following;
Improve customer satisfaction and retention
Reduce operating expenses
Enter new markets
Develop new, unique products
Before applying, know exactly how you will put your loan proceeds to work for your business. The loan application will ask this. Be prepared. If all you want to do is pay yourself a higher salary, don’t apply for a loan. Instead, use cash flow from operations to pay yourself. (A guy on Shark Tank got “the hook” from investors because he actually wanted to use investor money to support his lifestyle.)
A loan has to be paid back or else your credit rating suffers dramatically. Different types of loans have different payback terms; there are short-term and long-term loans.
The payback period of the loan should correspond to the life of the asset you’re financing with the loan proceeds. For example, if you’re financing inventory, use short-term credit. Because inventory will be turned into cash within the year, the loan should be paid back within the year.
If you’re financing property or equipment that takes years to depreciate, take out a mid-term or long-term loan. For example, a mortgage is a long-term loan. Typically, if a loan is made against an asset, like a home, the interest rate charged is lower than for what’s referred to as an unsecured loan because the lender has recourse if you default in paying the loan back. That’s what home foreclosures are all about; the bank takes back a home if the homeowner defaults on paying his or her mortgage. An unsecured loan is one that’s backed by your reputation and credit history but nothing tangible. The interest rate, a reflection of the risk of the loan, is almost always higher on unsecured loans because the risk of default is higher.
When to Apply for a Loan
As a recovering banker, I can tell you the best time to apply for a loan is when you don’t need one. That’s not a typo. It’s also counterintuitive. Think about it from the lender’s perspective. When your company is flush with cash in the strong sales period during the year, the financials look really great. Profits are up; cash flow is climbing. Your company is a great credit risk. For credit products like credit lines, apply for the line during the busy season or when you have a lot of cash on hand. (You typically don’t have to pay for the credit line unless you use it.) It’s likely that your credit terms will either be more lenient, or it will be far easier to get your loan approved if you take this advice.
Another time to apply for a loan is when you have a big customer order and you need to finance raw materials to fill the order. That’s what my business partner and I did when we owned Bedazzled Incorporated, our first company. Lands’ End Yacht Stores loved our screen printed beach wear and they gave us a humongous order. We felt like the dog that caught the bus. The challenge was, we didn’t have enough cash flow to pay for the raw materials and labor necessary to fill the order. The good news was, we financed the inventory at cost of goods then resold the inventory to Lands’ End at a wholesale price, which locked in gross profit.
The fact that we had an order in hand and were working with a large customer like Lands’ End went a long way to build credibility that we would not have had as a two-person, two-year-old business approaching lenders. We secured a seven-year SBA loan, and paid it back within eighteen months, which helped our credit rating. That improved credit rating reduced our cost of capital for the next loan.
Get Your Numbers in Order
Moe Abdou, a great man who interviewed me about my work, told me a statistic that blew my mind. He said most small-business owners are paying almost double what they should be in interest on their loans because they don’t have clean books. That means the lender can’t make an accurate assessment of risk because the books are a mess and don’t provide accurate data, so the lender overcharges you interest to cover the risk they cannot see. What if your income statement, cash flow statement and balance sheet were accurate, complete and up-to-date? What if just getting that done could save you thousands, maybe even tens of thousands, of dollars every year in interest overcharges?
Is it worth it to get your books in order? You bet.
Before you apply for a loan, please do this:
Hire a dynamite bookkeeper, Intuit ProAdvisor or CPA. This is what they do. Whatever you pay them is a fraction of what you’ll be saving on interest fees. It’s worth it.
Make your banker your strategic partner
If you follow the next piece of advice, it has the potential to change your future:
Stay in touch with your banker after you get the loan.
Let them know if a big order comes through.
If one of your products goes viral, and you’re working overtime to get the orders out, let them know.
Tell your banker and your suppliers if you win a $25,000 FedEx small-business grant.
Sharing great news makes them excited about what you’re doing. When that happens, they become your advocate inside their firm. It will make doing business much easier, less expensive and so much more exciting!
Looking for more? Find more of my small business financial resources at DawnFotopulos.com.