The Loan Application

A lender will make you fill out a loan application. Typically, the application asks for a great deal of information, some of which will be contained in the business plan:

● The loan amount requested.
● How, when and from where it will be repaid.
● Description of collateral.
● Names, personal financial statements and income tax returns for anyone who will personally guarantee the loan.
● General information about the business: name, addresses, phone numbers, tax ID numbers, year-end statements.
● Type of business and history of the busi-ness.
● Structure, management and ownership, including résumés.
● List of other businesses that the owners control.

● Complete audited financial statements for the last three years, including bal¬ance sheets, income statements and projections through the end of the year.
● Cash‑flow projections for the term of the note.
● Recent aging of accounts receivable.
● References from financial institutions with which your business has any kind of relationship.
● Customer references.
● Report on any significant developments for the business.
● Any additional material you want to include, such as brochures to help the lender understand the business.

Score Your Loan Worthiness

There’s a limit to the amount of debt any company can handle. Thus, no matter how smooth your presentation, your bank (or any other lender) will always evaluate how much debt you can afford. If you want to gauge your chances of receiving a favorable reception at a bank, there are a couple of techniques you can use. Lenders traditionally look at two ratios to test your ability to repay:
1. Interest coverage ratio: earnings before interest and taxes divided by interest charges. This basic ratio defines your ability to meet interest payments on time. Inflation has led to altered standards for many ratios, but this one remains unchanged. You should have $3 of operating earnings for each $1 in interest charges.
2. Debt-service ratio: This ratio is calculated as follows:
Earnings before interest and taxes Interest charges + Principal payments
1 – tax rate

Principal payments are adjusted for after-tax earnings because they are not tax deductible. The interest coverage ratio says nothing about your ability to meet debt repayments. This ratio corrects that failing. A ratio of 1 is critical; anything less and your company is in danger of default. To be safe, a ratio of 2 or more is desirable.

In addition to these ratios, there’s a technique called the Zeta scoring system. This is a propri¬etary computer model used by banks and other institutions to measure a company’s vulnerability to financial difficulties. Even if your bank does not use the Zeta system itself, your Zeta score should give some indication of how you stand according to traditional financing benchmarks.

The heart of the system is a group of financial ratios, each weighted according to its importance as an indicator of financial health. As with all numerical rating systems, the model has its flaws. Nevertheless, the Zeta scoring system has become one of the more common methods of evaluat¬ing a company’s financial underpinnings.
You should encounter little difficulty in computing your company’s Zeta score on your own by using data from your most recent financial statements. Here are the key elements and a hypo¬thetical illustration of how they were used by the XYZ Mfg. Company:

● Working capital. First, divide working capital (current assets minus current liabilities) by total assets. Then, to obtain the proper weight, multiply by 1.2. XYZ’s assets total $120 million, and working capital stands at $24 million. Thus, $24 million divided by $120 million = .20. When
.20 is multiplied by 1.2, the Zeta factor is 0.24.
● Cumulative profitability. Here, you divide retained earnings by total assets. This measure¬ment is weighted a little more heavily, so multiply the answer by 1.4. Retained earnings of XYZ amount to $54.4 million. The Zeta calculation for this component becomes $54.4 million divided by $120 million = 0.45 x 1.4 = 0.63.
● Return on assets. This measure of profitability is given the heaviest weight. Divide pretax profits by total assets. Then multiply your answer by 3.3. With pretax profits of $28.4 million, XYZ’s Zeta calculation for return on assets becomes $28.4 million divided by $120 million =
.24 x 3.3 = 0.79.
● Return on sales. Here, you measure how many sales dollars are generated by each dollar of assets. Divide sales by total assets. The weighting is neutral, so multiply by 1.0. Sales of $145 million for XYZ are divided by $120 million, producing a figure of 1.2. When multiplied by 1.0, the Zeta factor remains 1.2.
● Leverage. This final ratio is a bit different in that it attempts to measure the volatility of your company’s capital structure. Divide shareholders’ equity by your total debt. This final com¬ponent is negatively weighted, so multiply by 0.6. XYZ’s equity of $90.6 million is divided by a total debt of $33 million, producing a ratio of 2.75. This is multiplied by 0.6 for a Zeta factor of 1.65.

To arrive at your company’s Zeta score, merely add the scores for each individual component. If your final score is 3.0 or more, you are in good financial shape, according to the Zeta system. A score of less than 2.0 indicates that some problems exist, and anything less than 1.8 places a firm in the high-risk category. A negative score is supposed to foreshadow imminent bankruptcy. In XYZ’s case, the five components, added together, yield a total Zeta score of 4.51, or more than enough to justify a loan.

➤ Observation: Zeta scores are seldom crucial to a banker’s evaluation of your company. There are many other factors of at least equal importance. Nevertheless, if you find that your Zeta score is on the low side, you can prepare arguments to refute the implications. If you find that your Zeta score is satisfactory, you can cite it as evidence of financial health.