Demystifying the Loan Approval Process - What Banks Really Look For

If you are uncertain about whether your business will qualify for a bank loan of a certain amount, or what goes into the bank’s decision, here’s what I tell clients: It’s mostly about the math.

Primarily, qualifying for a bank loan is based on your business’s ability to repay the loan and the credit history of both your business and its owners. Here’s what you should understand before you apply for bank financing:

Debt Service Coverage

Many factors go into a bank’s decision to award a loan. But by far the most important is the borrower’s ability to make the loan payments. It sounds simple, but it usually comes down to this: Can the business afford to take on this new obligation?

To that end, the lender will start by evaluating your business’s ability to generate excess cash flow. To be more precise, the lender will calculate your “debt service coverage.”

Banks determine this by dividing a business’s historic net operating income (revenues minus certain operating expenses) by its debt obligations. Before awarding a loan, a bank will want to see that the business has debt service coverage of at least 1.2x. In other words, if you want to borrow $1 million to buy a building, and you will need to repay $100,000 a year on that loan (principal and interest), a bank will want your business to have excess annual cash flow of at least $120,000.

Before you apply for the loan, to avoid any surprises, it’s smart to do this calculation on your own.

Credit History

The lender will also want to know if the business and its owners have a solid record of paying bills on time. A strong credit history helps demonstrate reliability, while past challenges such as poor credit history or a history of charge-offs, may require some additional explanation, even if the math suggests you’ll be able to make the loan payments.

Before applying for a loan, it’s wise to review your credit reports and ensure they are accurate. Occasionally, inaccuracies appear in the report that don’t reflect your true financial picture. Working with the agencies to clear up those issues in advance may help strengthen your application. 

What Else Will the Lender Want?

To evaluate your ability to repay the loan, lenders will seek a number of documents.

At minimum, expect to be asked for three years of both personal and business tax returns and a personal financial statement. Depending on the type of loan, the bank might also ask for documents such as an accounts receivable schedule, financial projections, a budget and/or a business plan. If you’re buying real estate, the bank will also order an appraisal to confirm the value of the property you are purchasing.

Most banks will also ask any owner who has at least a 20% ownership share in the borrowing business to personally guarantee the loan.

Covenants and Other Obligations

Middle-market businesses seeking larger loans should also anticipate the lender assigning ongoing obligations beyond just making the loan payments. For instance, for a larger loan, a lender might require CPA-prepared financial statements on a regular basis, as often as quarterly.

Larger loans also can come with loan covenants. A typical one is a debt service coverage covenant that requires the borrower to continually meet a stipulated coverage ratio.

Your Bank Relationship

Yes, getting approved for a bank loan is mostly about the math. But sometimes there are mitigating circumstances that can tip the scales in your favor. For instance, maybe revenues were down last year because of an unexpected supply chain issue or unusual weather conditions.

The problem is extenuating circumstances won’t help your cause unless your banker is familiar with your business. That’s why communicating with your banker regularly is critical to your borrowing prospects.

Even if you only have a depository relationship today, it’s important to speak regularly with your banker. That way, when you need a loan, they know you and your business. Not only that, but your banker can be a valuable information resource, offering creative financing ideas and acting as a sounding board for your growth plans.

At Hancock Whitney, your dream is our mission. We’re committed to our communities and want to see business owners and entrepreneurs thrive. If your business needs to explore funding options, please contact one of our business bankers. We’re here to help you find the business loan that works for you and your company.