NFIB

Is Your Debt Load Affecting Your Chance of Getting a Loan?
06/ 25/ 2002

by Jeffrey Moses

Why do banks and other lenders pay close attention to a company's debt load when considering a loan? Because nothing is guaranteed to eat up a company's cash faster and more surely than having to pay back immediate debts. It's not unusual for a developing company to request a $100,000 loan, with an additional $100,000 line of credit. If the company has total annual revenues from $50,000 to $100,000 (even though profitability has not yet been achieved), this request may not seem unreasonable. But if the company owes creditors $50,000, the amount of usable cash from a $100,000 loan will immediately be slashed in half. Banks rarely like loaning money that will be used primarily to pay off debts, so this can be a deal killer.

When carrying a significant debt load, a company has two choices when applying for financing: Convince the lender that paying off the debt with some portion of the loan principal will not compromise the effectiveness of the loan or reduce the loan to a level that cannot be interpreted as compromising the loan's effectiveness.

To convince a lender that paying off debt is a natural and effective use of a portion of the loan amount, a company should present compelling evidence showing that the remaining cash will increase business and make payment of the loan probable. Lenders should be shown that the loan is not solely to pay off creditors (or accounts payable), but is primarily for the ongoing growth of the company.

In some cases, creditors could be contacted before the loan request, to see if they will put off any upcoming payment deadlines. This could ease a lender's concerns about the timing or amount of oncoming debt payments.

Generally, it's best to remove as much debt as possible before initiating the loan request. While this may seem obvious, a juggling act often arises between paying down debt and maintaining cash reserves. But it's often more advantageous from the standpoint of obtaining a loan to have $25,000 in cash reserves with only $25,000 in debt or accounts payable than to have $100,000 in reserves with $100,000 in debt or accounts payable. Certainly, it's necessary to keep cash reserves for emergencies, but reserves can be re-established once a loan is received.

The same can be said for an individual seeking financing for a start-up. Usually, banks examine the individual's personal financial statements, looking for both assets and liabilities. In this case, outstanding loans should be paid off or paid down (including credit card debt, car loans or leases, personal lines of credit, etc.). Mortgages often are not a primary consideration, unless monthly payments are excessive when compared to income history.

Work with your accountant or business adviser to determine your best-case position regarding debt load before applying for financing. They can help you with various financial measurements that banks often use when reviewing loan applications, including current assets to current liabilities ratio, debt to net worth ratio (usually for individuals), short-term debt to cash reserves ratio and long-term debt to projected revenue ratio among others.

Remember: banks are more likely to make loans when a person or company doesn't really need the money. The larger the debt load, the greater the appearance of need. Paying down debt load and brining it into a respectable percentage of cash reserves shows that you have thought the loan through and are more likely to pay back the loan.

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