Hi, Brandon Davis with Davis CPA Group. Today I want to talk about obtaining a bank loan, particularly for a business or bank financing. So let’s talk about bank financing today.
This is a topic that is going to be one that we’re going to probably do some videos off of this one because there’s a lot of information that we can talk about when you look at getting a bank loan or particularly if you’re starting a business, but there are things I want to talk about like debt service coverage ratios and your financial statements and things of that nature. Now I’ve got some videos on financial statements already that you could check out, but there are certain things that from this video I think we’re going to dive into deeper, but let’s kind of hit some high-level stuff.
So anytime you’re looking at getting a bank financing, there are certain things that you have to have in place to in order to get something done. All banks are going to ask for the same set of information more or less. Some of them may have a formal application they’ll have you fill out, particularly if you’re going to get what’s called an SBA loan, which I’ll put a pin in that, we’ll talk about that in a minute. But they may have a formal application process. And again, this is for business financing, so bank financing for a business.
And so the other thing that you’re going to fill out is what’s called a PFS. I’ve got a video on these, a personal financial statement. That’s what that stands for, personal financial statement. So that’s something they’re going to want. Basically look at my video and on personal financial statements. It’s in essence, your assets, your liabilities, and they calculate your net worth to see are you personally too leveraged to even have the ability to pay this debt back if the business weren’t to perform very well. So that’s kind of what they use that for.
Another thing that you’re going to have to give is usually two to three years worth of tax returns, two to three years worth of tax returns. And the reason they use tax returns is they feel like you’re going to report the minimum amount of income to the government, right? And so if you can cash flow off of these tax returns, then they feel pretty good about that.
The other reason they use tax returns too, that’s kind of a joke, but the other reason they use tax returns too is that it is a verifiable form of income. So you file that with the IRS and you give a copy to the bank and you may be thinking, “Well, I could just make up a copy. I give it to the bank. They don’t even know that.” Well, you can’t because what happens is they’re also going to have you sign a 4506 form, the bank will, which allows them to get a tax transcript to be able to verify the information you gave them matches what the IRS says. And so you can’t, I know some people are thinking, “Well, I’ll just give them whatever they need to see,” but no, you can’t do that. So two to three years worth of tax returns, and then with that form 4506, they will verify that data, so it kind of adds some credibility to the income. So that’s why they want the tax returns.
But they also may want some year-to-date numbers. They may want some year-to-date financial statements. And if you look back at my videos about income statements and balance sheets, that’s what they’re going to want, and particularly even the cash flow statement. Because they want to see how’s your business operating today? The tax returns tell me what it did yesterday or tell me what it did in the past. Well, I want to know how it’s doing right now.
And the other thing they might want, and particularly if you’re looking at doing a startup loan, is they’re going to want to see some projected financials. This is where it gets kind of tricky. You might have to get a professional involved, a CPA or something along those lines, in order to get a projection put together properly. Because projection is based on assumptions, but you got to have science behind those assumptions, that’s what I always tell people. We’ve got to come back and say, “Look, the business that you’re looking at doing, there’s probably other businesses like it out there. So we’ve got to use industry data that we can to figure out, okay, as a percent of income, if I were to sell 10 of these widgets or if I were to provide this service and get $10,000 a month in revenue, what should my expense profile look like based on that?” And so there’s industry data out there that we can use to help build these projections.
The other thing we use to build these projections is the local information that we have. So say, for example, it’s a business that we have been researching for a long time, we’re familiar with, or maybe we’ve been doing this kind of business on the side if you will.
If you go back to my example in one of my videos, we were a toy company selling toys. And so if we were a toy company selling toys, but I’ve been doing it on the side or I’ve been or I’ve been making little wooden toy cars or maybe rocking horses or something along those lines, and I sell those to people. Or maybe I just have a woodworking business in general where I make furniture. I make tables and chairs. And I have a job, and I’ve been doing some on the side. And so I’m starting to get kind of a clientele built up and people want my products.
Well, I can figure out kind of how much I can make on that because I know what the wood’s costing me. I know how much time I’m spending, and I know what space I’m using right now in my garage or my warehouse or what have you. And so you kind of factor in all of those costs to build up here’s where I think we would be if we sold 10 of them a month versus once a month. And so you start looking at the building by kind of working backward for what it takes to do what you do to get those projected financials put together.
So that’s step one. Application, financial statements, tax returns to verify income, year-to-date financials, maybe even projected financials. Well, they’re going to take that information and they’re going to look at it. They’re going to pull it, use the application and the financials and the PFS. They’re going to pull your credit report. And they’re going to want to see, use that as a guide to figure out, well, do you have a good payment history with the current debts that you have? Your personal credit is just as important as your business credit when it’s a small business because they look at the underlying owner’s information to make sure you can have the character, if you will, or the credibility to be able to pay that back.
So they’re going to pull your credit. So that’s a factor in this situation. The other thing they’re going to do is they’re going to look at the cash flows of your business. And they’re going to say, “Okay.” They’re going to figure something called the debt service coverage ratio. If you look up my video on EBITDA, they use EBITDA to do that. Earnings before interest, taxes, depreciation, amortization. Look up that video. It talks about how it’s calculated and what it’s used for. One of the things they use, they use EBITDA to calculate your debt service coverage ratio to make sure your project can stand on its own and in cash flow itself and then you can afford to pay back the debt if you will.
The other thing they’re going to do is they’re going to do a little bit of rate analysis. A lot of times business loans have some variable rate, particularly if it’s over a longer period of time. If it’s a shorter equipment note, maybe seven, 10 years, you might get the rate fixed for that period of time. But most banks, on business loans, will only fix your interest rate for around about five to seven years. And so what they do is say, “Okay, after five years, if interest rates go up 2%. Can you still cash flow it?”
So they’re going to do an analysis of your financials, and they’re going to analyze that with the debt that you’re asking for. They’re going to calculate your debt service coverage ratio, which let’s about that. I talked about that in another video. You’re probably asking, “Well, how do they debt service coverage ratio, Brandon?”
Here’s how they do that. They take your EBITDA number, that earnings before interest, taxes, depreciation, amortization. And they basically divide the total payments that you’re looking at. So say your principal interest payment’s going to be $2,000, and your EBITDA is $4,000, then your debt service coverage ratio is basically 2.0. So what they look at is a debt service coverage ratio of about 1.2 and above, plus, 1.2 are higher, as a good debt service coverage ratio and do them. But some of them may look at 1.15, 1.12, but I kind of think 1.2 should be worth shooting for. If we’re helping a client put together a package, say, “You got to be 1.2 your higher,” and making sure that we can service a debt that we’re asking for. So that’s kind of what that looks like.
So then after that, they may want to get a little more information from you to say, “Okay,” they’re going to come back with questions to kind of walkthrough and make sure you have the expertise and the experience and the knowledge to do the business that you’re in. If you’ve got a startup, you might need to provide a resume or you might even do a narrative of your experience and put together what’s called a business plan, particularly on the startup side.
So a business plan basically says, “Okay, here’s kind of a summary of what we’re doing. Here are some details why I’ve got the experience to do this. Here’s the homework we’ve done to say, ‘Here’s our… ‘” And almost do what they call SWOT analysis, where you’d look at your strengths, your weaknesses, your opportunities, and threats in the industry that you’re in.
And you really just kind of do your homework, right? I mean, make sure that you come to the table prepared and the banker sees that you’ve put all these things in place and you’ve really done a nice job of trying to figure out can you get this business started? Can you physically do the business? Yes, I feel like we can, and here’s why. Please give me the money and the investment to partner with me to get the project going. So the more homework and the more information you can provide a bank to make their job easier and make them understand that you’ve thought about this is going to help you successfully get some financing.
So again, this is some high-level stuff, kind of walking through the application process. Look at your credit, figure out your cash flows. They’ll do their own little analysis internally, and they’ll look at a business plan overall to see if you got the ability to get the project or the financing request in place. So happy to talk about these things in more detail at Davis CPA Group. And thanks for tuning in.