Over the past few months, we have witnessed the devastating economic impact of the COVID-19 pandemic. This unprecedented crisis has sent shockwaves across industries, including the financial sector, and they now face unique uncertainties that impact how and when they make loans and credit available.
Traditionally, the financial industry uniquely acts as a primary source of stability. Most traditional financial institutions, such as banks, play a vital role in the functioning of the economy. They do so by delivering important services to individuals and communities such as guarding savings and investments, providing sound credit and financing, and acting as critical conduits for credit and loan forgiveness from programs such as the Paycheck Protection Program.
Although banks in the United States entered the COVID-19 with ample cash and liquidity, they face mounting pressures in the road ahead. With the devastated economy, near-zero interest rates and a flattened yield curve means diminished net interest income that would hurt their financial position. Furthermore, it is expected that credit losses could exceed $1 trillion.
Underwriting is a fundamental tool that business lenders, such as banks,use to assess risk and determine if a potential borrower is creditworthy and should or should not be granted credit. Prior to COVID-19, the underlying principle in underwriting was that past performance could predict future credit risk. As such, underwriting factors pegged to historical data such as a business’s tax returns were emphasized. However, the pandemic has flipped this principle on its head. Now, underwriting factors that rely on past data, or data before the onset of COVID-19, is less relevant in the underwriting process.
Although every business lender differs in how they adjust their underwriting procedure, it is expected that new borrowers will undergo greater scrutiny and have to cough out more financial information, such as present-day financial statements, for vetting and risk assessment purposes.
As such, here are 5 red flags that banks will look out for when considering a small business loan application. By being aware of these red flags, you can correct them before applying for small business credit.
What are the red flags?
Low personal credit score
Low business credit score
Poor financial health as reflected on financial statements
Short time of business in operations
Although you may be applying for a small business loan, business lenders will pull your personal credit score and request for your personal information such as income, net worth, available credit, prior delinquencies, and prior bankruptcy. This is because it follows the logic that the diligence and reliability of small businesses making timely credit or loan payments are reflected in the small business owners themselves. This is especially critical if the small business loan requires you as the owner to put up a personal guarantee. As such, we recommend aiming for the threshold of 760 and beyond to demonstrate strong personal finance and credit management. To boost your credit score over time, ensure that you pay all your bills on time and spend below the credit limit at ideally, 30% or less. You may also review your personal credit reports at Annual Credit Report at least once a year to find out what your credit standing is and dispute any inaccuracies.
A business has its own credit score. While the three credit bureaus, Experian, Equifax, and Dun & Bradstreet differ in their scoring model, they do put weightage on the following list of common factors: Company size, age of credit history, payment history, industry risk, and debt usage. It is imperative that the business does not have a low credit score as this would be a glaring red flag. It can be assumed that a business with a low credit score has a history of insufficient or poor payment history and will turn off most lenders. Conversely, paying bills to suppliers and lenders on time is the best way to boost scores into the ‘excellent’ range of 80 and beyond.
As mentioned earlier, business lenders or lending institutions are likely to request past and present financial statements. This could refer to last year’s financial statements and balance sheets as well as an interim financial statement of the recent COVID-19 affected months. Other statements you would need on hand are your income statement and cash flow statement. Although the weightage of the underwriting factors may differ across business lenders, various information pooled from these documents will help them better understand your business’ financial position.
For instance, cash flow would be an important indicator for them as it informs lenders if you can settle business debt in a timely fashion or be at risk of being late for payments and potentially defaulting on a loan. Similarly, your debt-to-income ratio will be considered in your small business loan application as lenders would want to assess how much pressure your existing debt is exerting on your budget and thereby, your ability to take on even more debt.
As such, red flags that lenders would look out for in financial statements would include: negative cashflow, a high number of NSFs (non-sufficient funds) in the past month, insufficient collateral and a high debt-to-income ratio.
It is commonly assumed that the older your business, the more stable it would be and presents less risk than a new one. As such, business lenders may be more cautious if the business has been operational for two years or less. That said, if you fall short of the specified period, it is still possible to apply if you are able to prove a strong business plan or put up collateral.
Each industry has a different level of risk. This is especially so in this uncertain economy where the pandemic has asymmetrically impacted industries. If your business is in a greatly impacted industry such as travel and hospitality, this would affect your chances of success. It is even more pertinent to show a solid business plan, excellent credit score, and even put up collateral.
Additionally, each business lender will have a different list of industries or the nature of businesses that they will shy away from. This may include not-for-profits, firearms, gambling, and adult entertainment. Ensure you check with your preferred businessthe lender on any industry preclusions before submitting your application. It is also important to correctly identify your industry code. You can look up your code on the North American Industry Classification System (NAICS) website. This will prevent delays or mistaken rejection of the application.
Due to COVID-19, banks are forced to approach with caution by tightening lending standards. In a recent survey conducted by the Federal Reserve, senior loan officers reported that lending standards are the tightest since 2005. To improve your chances of success, it is important that you, as a business owner, are aware of these underwriting factors. By knowing the red flags that business lenders will look out for, you can work on correcting them.
With the help of Tillful, you will be able to view and monitor your real-time business credit score that serves as a reflection of your business’ overall financial health. At the touch of your fingertips, this free-to-use Tillful app will help you understand the factors that affect your small business credit rating, so you may take control of the business’ financial health and unlock capital when you need it.