Decoding Small Business Financing Terms: A Guide
When you’re new to the world of business funding, the fine print can read like a calculus textbook. So, we put together a list of small business financing terms to get you started, so you can go into the application process with the confidence and knowledge to make the right decision for your business.
APR stands for “Annual Percentage Rate.” A loan’s interest rate may get top billing, but it’s this number you should carefully examine. Why? Because APR includes all associated costs or fees involved in taking out the loan and is an annualized rate, providing you with the actual cost per year of borrowing money. Consequently, it’s the best metric for making an “apples-to-apples” comparison of competing loan offers. Most lenders are required by The Truth in Lending Act to disclose the APR. But if you want to calculate APR on your own, there’s also a number of handy calculators available.
An intimidating word for a straightforward concept. Amortization simply means dividing up the cost of something over a period of time. You might be paying off a small business loan. Or, you may be averaging out the price of your new office furniture over its 5-year lifespan for tax purposes. In the context of business funding, an amortization schedule refers to the length of time and the fixed (or evenly distributed) size and frequency of payments you’ll make to pay back your loan. A higher percentage of each payment will go towards your interest charges in the loan’s early days, but as you begin to make regular payments, a more significant percentage will shift to your principal.
Business Credit Score
Businesses, like people, come with credit scores. Lenders use this number to determine if your business has a record of being financially responsible. And like your personal score, your business will be judged on things like its record of paying bills on time, its ability to avoid legal trouble with creditors, and its length of time in business. Don’t panic if you’re quoted a low score: personal credit scores range from 300 to 850, but business credit scores generally range from 0 to 100.
Ever wonder where your credit score comes from? Companies called credit bureaus collect and monitor information on consumer credit. The lender then uses this insight to make decisions about potential loan candidates.There are dozens of credit bureaus across the country, but you’re probably familiar with the big three: Equifax, Experian, and TransUnion.
Keeping track of multiple loan payments can be tough, especially when you’re a small business owner who is already juggling one million things. When you have many loans to keep track of, this is where business debt consolidation comes in. By consolidating business debt, you roll several forms of debt into one new loan, which streamlines your debt repayments into a single monthly payment — and in some cases, can even land you a more affordable APR.
It’s a perennial problem: small businesses struggle with cash flow, but owners don’t want to give up control of their company. Thankfully, there’s debt financing. With debt financing, you borrow money (which you then pay back with interest) to fund your business. In contrast, equity financing involves selling shares of a company to investors in exchange for capital. Debt financing could cover a business’s short-term needs via credit cards or small lines of credit. Or, it could support longer-term growth investments with a multi-year loan.
Debt Service Coverage Ratio (DSCR) is a crucial calculation for lenders to determine a business’s capacity to repay a loan. It’s calculated by dividing your annual net income by your “annual debt service.” Annual debt service is the money required over a year to pay debts. You’re hoping for a higher ratio here since it’ll prove that your business has enough cash available to cover your loan payments and any associated fees even if cash flow fluctuates from month to month. Every lender has a different minimum DSCR they’ll accept before granting a loan, but you’ll want your number to be 1.25 or higher before you book an appointment.
The balance sheet provides you with a comprehensive picture of your business’ financial situation at a given point in time. Here you’ll track every asset, liability, and equity held by the company It’s called a balance sheet because your assets have to balance out with your liabilities and equity when you’re finished. Keeping an accurate and up-to-date balance sheet should be your top bookkeeping priority.
Cash Flow Statement
A cash flow statement is a list of where the money’s coming from and where it’s going. It’ll help you understand how the changes on the balance sheet are affecting your cash on hand. A cash flow statement has three categories: operating, investing, and financing activities and includes dates and details of each transaction.
Also called a ‘profit and loss statement’ or a ‘statement of operations,’ an income statement is a simplified document that reports on a business’ revenues, expenses, profits, and losses during a specific period.
Interest rate is expressed as a percentage of the principal, interest rate is the amount a lender charges for you to borrow money. See APR for a complete picture of what you’ll be paying.
We know it’s tempting to see a $1,000,000 sales report and immediately book a trip to Costa Rica. But this revenue isn’t the full picture of your business’ viability. First, you’ll need to calculate your net income. Net income is what your business brings in after all expenses have been deducted. Your net deductions include expenses like COGS (cost of goods sold), taxes, and depreciation. Let’s say your business brought in $1,000,000 last year. Your gross income might be a cool million, but after subtracting the $800,000 you spent on business expenses, your business’ net income is only $200,000.
Underwriting can be hard work. As a result, lenders will commonly charge an “origination fee” to cover the costs of evaluating and originating a loan. The origination fee could be a flat fee, but it’s usually expressed as a percentage of the principal amount. Let’s say you’re approved for a $50,000 loan with an origination fee of 5 percent. The lender will deduct that 5 percent ($2,500) right off the bat, then give you the remaining $47,500.
Personal Credit Score
How does a lender determine who’d make a good candidate for a loan? Sure, they could take every applicant out for coffee, but analyzing a three-digit number is a lot easier for evaluating your financial responsibility as a business owner. This personal credit score paints a picture of a person’s history managing their debts and other financial obligations. It’s based on five primary factors: payment history, the total amount of debt owed, length of credit history, diversity of credit types, and whether a lot of new credit has recently been requested. Credit scores range from 300 to 850, but generally speaking, anything above 700 will prove your financial savviness to lenders.
Lending to a small business is considered a risky endeavor. Even the author of the world’s most comprehensive business plan could run into unexpected challenges. It’s for this reason that lenders may require you to sign a personal guarantee. If the business is unable to pay its debts down the line, the signer of the guarantee agrees to pay them personally. Personal guarantees are common these days, as lenders like to see some “skin in the game.”
It’s Personal Finance 101: pay off debts as soon as you can, right? Well, with small business loans, there might just be a penalty for early repayment. Lenders can charge borrowers a “prepayment penalty” to recoup the interest they’ll lose from the loan’s early repayment. If you’re hoping to avoid these charges, make sure you understand the payment conditions before taking out a loan. And if you’re currently in a loan that has a prepayment penalty, do a cost-benefit analysis to see if you’re better off waiting to pay your loan per the agreed-upon schedule.
A loan is broken down into two parts: the interest and the principal. The principal is simply the amount of money you’ve borrowed and have yet to pay back.
Make a sale, earn revenue. Revenue is simply the amount of money that your business activities bring in. The revenue doesn’t factor in things like expenses or staff time. If you’re looking at your total revenue over a more extended period, be sure to factor in discounts or deductions for returned merchandise.
It’s important to know whether the work you’re doing is actually worth the energy (and money). ROI stands for “Return on Investment.” It’s an excellent method for assessing the value of everything from selling a new product to bringing on an HR person. Here’s a (highly simplified) example. If you spend $1,000 on a print media advertising campaign and observe a $2,000 boost in sales the following week, your ROI for the campaign is 100%. Of course, ROI isn’t always this easy to calculate once you factor in things like the cost of goods sold or the time spent designing the ad campaign.
Don’t mess with the IRS. If you have unpaid federal tax obligations, the IRS can file a federal tax lien with the county government where you live or conduct business. A tax lien is a claim against your business’s assets. A tax lien becomes a matter of public record, will show up on your credit report, and will severely limit your ability to sell your business or acquire new credit. The tax lien will remain on your business until you pay off the full amount, or negotiate an alternate payment arrangement. Note: the government also reserves the right to seize your business if you don’t get serious about your payments.
With a term loan, you borrow a lump sum of capital upfront. You then pay it back with regular payments over a set period. Term loans usually span 1-5 years, although they can go as high as 20, and tend to follow monthly repayment schedules.
Often misunderstood as a business’ cash on hand, working capital actually refers to whether a company has enough short-term assets to cover its short-term liabilities. It’s a necessary calculation that provides a quick snapshot of a business’s financial health. The formula looks like this: Current Assets / Current Liabilities = Working Capital. Assets could be cash in the till, your shop’s inventory, or its short-term investments, while current liabilities could be things like account payable or accrued taxes. A result below 1 is a cause for concern, while anything over 2 means you should think about investing your excess assets. Lucky you!
A Final Note on Small Business Financing Terms
This list of small business financing terms is not exhaustive by any means. However, familiarizing yourself with this lingo will help you navigate the world of small business funding with more confidence and ease.