The ABCs of Borrowing

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Copyright 1990, Mark Van Note. All rights reserved. No part
of this publication may be reproduced, transmitted or transcribed
without the permission of the author. SBA retains an irrevocable,
worldwide, nonexclusive, royalty-free, unlimited license to use
this copyrighted material.

While we consider the contents of this publication to be of
general merit, its sponsorship by the U.S. Small Business Admin-
istration does not necessarily constitute an endoresment of the
views and opinions of the authors or the products and services of
the companies with which they are affiliated.

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All of SBA’s programs and services are extended to the public on
a nondiscriminatory basis.

INTRODUCTION

All businesses, no matter what size, will at some time need to
raise more money. For small businesses, the owner may be able to
dip into his or her personal savings, or friends may be able to
lend the needed money. Usually, however, the owner will have to
look to outside sources for financing.

IS YOUR FIRM CREDIT WORTHY?

Obtaining money when you need it is as necessary to the operation
of your business as a good location or an adequate labor force.
Before a bank will lend you money, the loan officer must feel
satisfied with the answers to the following questions.

* What is your character – will you want to repay the loan? How
capable are you in managing the business – will you be able to repay
the loan?
* What is the specific purpose of the loan? Is it a short- or
long-term need?
* Do you have a clear financial plan and forecast showing why you
need the loan and how you will pay it back?
* Is the loan request large enough to cover any unexpected change
in your situation, but not so large that its repayment will be a
heavy burden?
* What is the general economic outlook for your business and
industry?
* Do you have a reasonable amount at stake in the business?
* What collateral is available to secure the loan amount?

FINANCIAL INFORMATION REQUIRED BY LENDERS

The two basic financial documents that lenders require are the
balance sheet and the income statement. The balance sheet is the
major yardstick for solvency and the income statement is the
common measure of profits. Using these and other sources, lenders
ask the following questions.

General Questions

* Are the business’s books and records up-to-date and in good
condition?
* Does the business have a lawyer and/or accountant?
* Who are the customers and what percentage of total sales do the
largest customers represent?
* Are all obligations paid promptly?
* What is the insurance coverage?

Accounts Receivable

* What is the quality of the accounts receivable?
* Have any been pledged to another creditor?
* Are customers paying you promptly?
* Is there an allowance for bad debts?

Inventory

* Can the merchandise be sold at full price?
* How much raw material is on hand?
* How much work is in progress?
* How much of production is finished goods?
* Is too much money tied up in inventory?
* Is the inventory turnover in line with industry norms?

Fixed Assets and Equipment

* What is the type, age and condition of the equipment?
* What are the depreciation schedules?
* What are the details of mortgages or leases?
* What are the future fixed asset and equipment needs for the
company?

The lender scrutinizes the cash flow of the business to determine
whether or not the owner-manager is providing sufficient cash to
meet the firm’s obligations. The lender also makes sure that cash
needed for working capital is not being diverted to other areas,
such as the acquisition of fixed assets, thereby reducing
liquidity.

WHAT TYPE OF LOAN?

When you set out to borrow money for your firm, it is important
to know the type of loan you want and its duration. There are two
basic kinds of loans – lines of credit and installment loans – and two
general categories of loan length – short-term and long-term.

The purpose for which the funds are to be used is a very
important factor in deciding what kind of loan to request. There
is also an important connection between the length of the loan
and the source of repayment. Generally, short-term loans are
repaid from the liquidation of the current assets (i.e.,
receivables, inventory) that are financed, while long-term loans
are generally repaid from earnings.

Line of Credit

A line of credit is an arrangement in which the bank disburses
funds as they are needed, up to a predetermined limit. The
customer may borrow and repay repeatedly up to the limit within
the approved time frame (usually one year).

Installment Loan

An installment loan is an agreement to provide a lump sum amount
of money at the beginning of the loan. The loan is paid back in
equal amounts over the course of a number of years.

Short-term loan

A short-term bank loan can be used for purposes such as financing
a seasonal buildup in accounts receivable or inventory. Lenders
usually expect these loans to be repaid after their purposes have
been served: for example, accounts receivable loans when the
outstanding accounts have been paid by the customers and
inventory loans when the inventory has been sold and cash
collected. Short-term loans are generally repaid in less than a
year.

Long-term loan

A long-term loan is usually a formal agreement to provide funds
for more than one year, and most are for an improvement that will
benefit the company and increase earnings. An example is the
purchase of a new building that will increase capacity or of a
machine that will make the manufacturing process more efficient
and less costly. Long-term loans are usually repaid from profits.

COLLATERAL

Sometimes your signature and general credit reputation are the
only collateral the bank needs to make a loan. This type of loan
is called unsecured. At other times, the bank requires a pledge
of some or all of your assets as additional assurance that the
loan will be repaid. This is called a secured loan. The kind and
amount of collateral depends on the bank and on variables in the
borrower’s situation.

Many types of collateral can be pledged for a secured loan. The
most common are endorser, warehouse receipts, floor planning,
purchase money security interest (PMSI) in furniture and/or
equipment, real estate, accounts receivable inventory, savings
accounts, life insurance policies, and stocks and bonds.

Endorser, Co-maker, Guarantor

A borrower may ask another person to sign a note in order to
augment his or her credit. This endorser is then liable for the
note: if the borrower fails to pay, the bank expects the endorser
to pay. Sometimes the endorser may also be asked to pledge
assets.

A co-maker is an endorser who assumes an obligation jointly with
the maker, or borrower. In this arrangement, the bank can collect
directly from either maker or co-maker.

A guarantor is an endorser who guarantees the payment of a note
if the borrower does not pay. Both private and government lenders
often require guarantees from officers of corporations in order
to assure continuity of effective management.

Warehouse Receipts

A bank may take commodities as collateral by lending money on a
warehouse receipt. The receipt is usually delivered directly to
the bank and shows that the merchandise has either been placed in
a public warehouse or has been left on your premises under the
control of one of your employees who is bonded. Such loans are
generally made on staple or standard merchandise that can be
readily marketed. The typical loan is for a percentage of the
cost of the merchandise.

Floor Planning

Merchandise such as automobiles, appliances and boats must be
displayed to be sold, but the only way many small marketers can
afford displays is by borrowing money. Such loans are often
secured by a note and trust receipt. The trust receipt is used
for serial numbered merchandise. It acknowledges receipt of the
merchandise, shows agreement to keep the merchandise in trust for
the bank and verifies the promise to pay the bank as the goods
are sold.

Purchase Money Security Interest

If you buy expensive equipment, such as a cash register or a
delivery truck, you may be able to get a loan using the equipment
as collateral. (This kind of loan is also called a chattel
mortgage.) The bank assesses the present and future market value
of the equipment and makes sure it is adequately insured.

Real Estate

Real estate is another form of collateral, usually for long-term
loans. In evaluating a real estate mortgage, the bank considers
the market and foreclosure value of the property and its
insurance coverage.

Accounts Receivable

Many banks lend money against accounts receivable; in effect,
counting on your customers to pay your loan. The bank may take
accounts receivable on a notification or nonnotification plan.
Under the notification plan, the purchaser of the goods is
informed by the bank that the account has been assigned and is
asked to make payments directly to the bank. Under the
nonnotification plan, customers continue to pay you and you pay
the bank.

Inventory

Inventory is the merchandise, wares and any assets that can be
liquidated of a retail, wholesale or manufacturing business that
will provide a form of financial guarantee against the loan
proceeds. Unless otherwise specified in the loan documents, plant
and equipment (e.g., computers, cash registers, manufacturing
equipment, telephones and other fixtures) can also be included as
inventory to be held as collateral.

Savings Accounts and Certificates of Deposit

It is possible to get a loan by assigning a savings account to
the bank. You assign the account and the bank keeps the passbook.
If you assign an account at another bank as collateral, the
lending bank asks the other bank to mark its records to show that
the account is held as collateral.

Life Insurance

Another kind of collateral is the cash value of a life insurance
policy, in which you assign the policy to the bank. Some people
prefer to use life insurance as collateral rather than borrowing
directly from the insurance company because a bank loan generally
is easier to obtain and carries a lower interest rate.

Stocks and Bonds

Marketable stocks and bonds are also sources of collateral. Banks
usually lend 75 percent or less on the value of high-grade stocks
and up to 90 percent on government securities. The limits leave a
cushion or margin for protection against declines. If the market
value of the collateral does fall below a certain level, the bank
may ask for additional collateral or a partial payment of the
loan.

THE LOAN AGREEMENT

A loan agreement is a tailor-made document, fully stating all the
terms and conditions of the loan. It gives the amount of the loan
and terms of repayment, identifies the principle parties and
lists any restrictions placed on the borrower.

Limitations

Banks often include limitations in a loan agreement that restrict
what an owner can do. These limitations depend to a great extent
on the company. If the company is a good risk, the limitations
will be minimal. A higher risk company, on the other hand, will
have greater limitations. The three principle limitations involve
repayment terms, the use of collateral and periodic reporting.
Limitations are spelled out in the covenant section.

Covenants – Negative and Positive

Negative covenants are restrictions placed on the borrower by the
lender. Some examples are limitations on the borrower’s total
debt, agreement not to pledge assets to other creditors and
limitations on the amount of dividends that may be issued.

Positive covenants are all actions the borrower must agree to.
They include maintaining a minimum working capital, carrying
adequate insurance, adhering to the repayment schedules and
supplying the lender with regular financial statements and
reports. Loan agreements can be amended from time to time and
exceptions made. Certain provisions may be waived from year to
year with the consent of the lender.

Negotiating with the Lender

Ask to see the papers before the loan closing. Reputable lenders
will be glad to comply. While you’re mulling over the terms you
may want to get the advice of your associates and advisors.
Discuss and negotiate the lending terms before you sign the loan
agreement – it is good practice, no matter how much you need the
money. Chances are the lender may be willing to give on some of
the terms; try to get terms with which you know your company can
live. Remember, though, that once the loan is made, you are bound
by it.

THE LOAN APPLICATION

Banks and other lending institutions, including the SBA, require
a loan application on which you list certain information about
your business.

SBA Form 4 is an example of a loan application. It is more
detailed than most bank forms, because the bank usually has the
advantage of prior knowledge of the applicant and his or her
activities, while SBA usually does not have such knowledge. Also,
the longer maturities offered on SBA loans ordinarily require
more information about the applicant.

Before you fill out a loan application, you should talk with an
SBA representative, or your accountant or banker, to make sure
that your business is eligible for an SBA loan. Because of public
policy, SBA cannot make certain types of loans, nor can it make
loans under certain conditions. For example, if you qualify for a
loan on reasonable terms from a bank, SBA cannot lend you money.
You also are not eligible for an SBA loan if you can get funds by
selling assets that your company does not need in order to grow.

Most sections of the SBA loan application are self-explanatory;
however, some applicants have trouble with certain sections
because they do not know where to get the necessary information
requested.

The collateral section is an example. Collateral is the
borrower’s assets that are pledged to the lender to guarantee the
loan. Your company’s books should show the market value of assets
such as business real estate and business machinery and
equipment. (Market means what you paid for such assets less
depreciation.) If your records do not contain detailed
information on these assets, the bank sometimes can get it from
your federal income tax returns. Reviewing the depreciation that
you have taken for tax purposes on such assets can help to
ascertain their value.

If you are a good manager, you probably balance your books every
month. Some businesses, however, prepare balance sheets less
regularly. In filling out your Balance Sheet as of ________,
19___, Fiscal Year Ends______, remember that you must show the
condition of your business within 60 days of the date on your
loan application. It is best to get expert advice when working up
this vital information. Your accountant or banker can help you.

Again, if your records do not show the details necessary for
working up income (profit and loss) statements, your federal
income tax returns may be useful in getting together facts for a
loan application.

APPENDIX A: APPLICATION FOR BUSINESS LOAN

(This document is not currently available)

APPENDIX B: CASH BUDGET
(For three months ending March 31, 19__)

January February March
budget Actual budget Actual budget Actual
______________________________________________________________________
Expected cash receipts:
1. Cash sales ___ ___ ___ ___ ___ ___
2. Collections on
accounts receivable ___ ___ ___ ___ ___ ___
3. Other income ___ ___ ___ ___ ___ ___
4. Total cash receipts ___ ___ ___ ___ ___ ___

Expected cash payments:
5. Raw materials ___ ___ ___ ___ ___ ___
6. Payroll ___ ___ ___ ___ ___ ___
7. Other factory expenses
(including maintenance) ___ ___ ___ ___ ___ ___
8. Advertising ___ ___ ___ ___ ___ ___
9. Selling expense ___ ___ ___ ___ ___ ___
10. Administrative expense
(including salary of
owner-manager) ___ ___ ___ ___ ___ ___
11. New plant & equipment ___ ___ ___ ___ ___ ___
12. Other payments (taxes
including estimated
income tax; repayment of
loans; interest; etc.) ___ ___ ___ ___ ___ ___
13. Total cash payments ___ ___ ___ ___ ___ ___

14. Expected cash balance at
beginning of the month ___ ___ ___ ___ ___ ___
15. Cash increase or decrease
(item 4 minus item 13) ___ ___ ___ ___ ___ ___
16. Expected cash balance at
end of month (item 14
plus item 15) ___ ___ ___ ___ ___ ___
17. Desired working cash
balance ___ ___ ___ ___ ___ ___
18. Short-term loans needed
(item 17 minus item 16
if item 17 is larger) ___ ___ ___ ___ ___ ___
19. Cash available for divi-
dends capital cash ex-
penditures and/or short
investments (item 16
minus item 17 if item 16
is larger) ___ ___ ___ ___ ___ ___

Capital cash:
20. Cash available (item 19
after deducting dividends
etc.) ___ ___ ___ ___ ___ ___
21. Desired capital cash
(item 11 new plant
equipment) ___ ___ ___ ___ ___ ___
22. Long-term loans needed
(item 21 less item 20 if
item 21 is larger) ___ ___ ___ ___ ___ ___

APPENDIX C: GLOSSARY

Accounts receivable Money your customers owe you that you have
sent them a bill for.
Bad debt Money owed to you that is not repaid.
Cash flow The movement of money into and out of your
business.
Collateral Item (equipment,, property,, etc.) that is
pledged to guarantee a loan.
Covenant Prescription for action in a loan agreement.
Current assets Money, inventory and equipment that will be
used up in the short term (usually within
one year).
Depreciation schedule Accounting procedure for determining the
amount of value left in a piece of equipment.
Financial forecast Projection of revenues and expenses for the
next one to five years.
Financial plan Outline for how to use the money (capital) you
have and how to raise the money you will need.
Fixed assets Equipment, buildings, etc., that are purchased
and used for long-term purposes.
Inventory Merchandise that is purchased and/or produced and
stored for eventual sale.
Inventory turnover How often the inventory is sold and
replenished in one year.
Liquidation Sale of products or merchandise.
Long term Period usually greater than one year.
Obligation Money, merchandise or service owed to someone.
Another term for debt.
Short term Period usually one year or less.
Solvency The ability to continue business.
Working capital Cash and short-term assets that can be used for
current needs (bills, etc.).

APPENDIX D: INFORMATION RESOURCES
U.S. Small Business Administration (SBA)

The SBA offers an extensive selection of information on most
business management topics, from how to start a business to
exporting your products.

This information is listed in “The Small Business Directory”. For
a free copy contact your nearest SBA office.

SBA has offices throughout the country. Consult the U.S.
Government section in your telephone directory for the office
nearest you. SBA offers a number of programs and services,
including training and educational programs, counseling services,
financial programs and contract assistance. Ask about

– Service Corps of Retired Executives (SCORE), a national
organization sponsored by SBA of over 13,000 volunteer business
executives who provide free counseling, workshops and seminars
to prospective and existing small business people.

– Small Business Development Centers (SBDCs), sponsored by the SBA
in partnership with state and local governments, the educational
community and the private sector. They provide assistance,
counseling and training to prospective and existing business
people.

– Small Business Institutes (SBIs), organized through SBA on more
than 500 college campuses nationwide. The institutes provide
counseling by students and faculty to small business clients.

For more information about SBA business development programs and
services call the SBA Small Business Answer Desk at 1-800-8-ASK-SBA
(827-5722).

Other U.S. Government Resources
Many publications on business management and other related topics
are available from the Government Printing Office (GPO). GPO
bookstores are located in 24 major cities and are listed in the
Yellow Pages under the “bookstore” heading. You can request a
“Subject Bibliography” by writing to Government Printing Office,
Superintendent of Documents, Washington, DC 20402-9328.

Many federal agencies offer publications of interest to small
businesses. There is a nominal fee for some, but most are free.
Below is a selected list of government agencies that provide
publications and other services targeted to small businesses. To
get their publications, contact the regional offices listed in
the telephone directory or write to the addresses below:

– Consumer Information Center (CIC), P.O. Box 100 Pueblo, CO 81002
The CIC offers a consumer information catalog of federal
publications.

– Consumer Product Safety Commission (CPSC)
Publications Request
Washington, DC 20207
The CPSC offers guidelines for product safety requirements.

– U.S. Department of Agriculture (USDA)
12th Street and Independence Avenue, SW
Washington, DC 20250
The USDA offers publications on selling to the USDA.
Publications and programs on entrepreneurship are also available

through county extension offices nationwide.

– U.S. Department of Commerce (DOC)
Office of Business Liaison
14th Street and Constitution Avenue, NW
Room 5898C
Washington, DC 20230
DOC’s Business Assistance Center provides listings of
business opportunities available in the federal government. This
service also will refer businesses to different programs and
services in the DOC and other federal agencies.

– U.S. Department of Health and Human Services (HHS)
Public Health Service
Alcohol, Drug Abuse and Mental Health Administration
5600 Fishers Lane
Rockville, MD 20857
Drug Free Workplace Helpline: 1-800-843-4971. Provides
information on Employee Assistance Programs.
National Institute for Drug Abuse Hotline:
1-800-662-4357. Provides information on preventing substance
abuse in the workplace.
The National Clearinghouse for Alcohol and Drug Information:
1-800-729-6686 toll-free. Provides pamphlets and resource
materials on substance abuse.

– U.S. Department of Labor (DOL)
Employment Standards Administration
200 Constitution Avenue, NW
Washington, DC 20210
The DOL offers publications on compliance with labor laws.

– U.S. Department of Treasury
Internal Revenue Service (IRS)
P.O. Box 25866
Richmond, VA 23260
1-800-424-3676
The IRS offers information on tax requirements for small
businesses.

– U.S. Environmental Protection Agency (EPA)
Small Business Ombudsman
401 M Street, SW (A-149C)
Washington, DC 20460
1-800-368-5888 except DC and VA
703-557-1938 in DC and VA
The EPA offers more than 100 publications designed to help small
businesses understand how they can comply with EPA regulations.

– U.S. Food and Drug Administration (FDA)
FDA Center for Food Safety and Applied Nutrition
200 Charles Street, SW
Washington, DC 20402
The FDA offers information on packaging and labeling
requirements for food and food-related products.

For More Information
A librarian can help you locate the specific information you need
in reference books. Most libraries have a variety of directories,
indexes and encyclopedias that cover many business topics. They
also have other resources, such as

– Trade association information
Ask the librarian to show you a directory of trade associations.

Associations provide a valuable network of resources to their
members through publications and services such as newsletters,
conferences and seminars.

– Books
Many guidebooks, textbooks and manuals on small business are
published annually. To find the names of books not in your local
library check “Books In Print”, a directory of books currently
available from publishers.

– Magazine and newspaper articles
Business and professional magazines provide information that is
more current than that found in books and textbooks. There are
a number of indexes to help you find specific articles in
periodicals.

In addition to books and magazines, many libraries offer free
workshops, lend skill-building tapes and have catalogues and
brochures describing continuing education opportunities.

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