If you’re a small business owner looking to borrow money, you might be uneasy about whether you’ll qualify for credit, especially if you own a business that doesn’t appear to be profitable. While it’s true that certain small business lenders only work with profitable businesses for certain types of business credit, other lenders are more flexible.
Here’s what you need to know about business profitability and borrowing money.
What is Profitability, Anyways?
Before you can say whether your business is profitable or not, you need to know what “profitability” actually means. According to Business Dictionary, profitability is “the state or condition of yielding a financial profit or gain.” (We recommend this more detailed Study.com definition if you’re looking for one.)
Profitability is the capability of a business to earn a profit. A profit is what’s left of the revenue a business generates after it pays all expenses directly related to the generation of the revenue, like producing a product, paying employees, and other expenses related to the conduct of the business activities.
For your business to be profitable, your expenses should consistently be less than your income. A business’s profitability is shown on a Profit & Loss Statement. For more information, Iowa State University has a useful Understanding Profitability page on their website.
Traditional Lenders Avoid Risk When It Comes to Business Loans
Many traditional small business lenders (yes, that’s you, big banks) are risk-averse. They don’t want to take a chance on lending money to a business that won’t be able to pay them back—they have shareholders to answer to. That’s why they’ll often only work with businesses that can show that they’re profitable. Also, if the lender is offering SBA-guaranteed loans, they must follow the SBA eligibility requirements, which usually include proof of profitability.
Why Income History and Cash Flow Matters to (Some) Lenders
Small business owners looking for a loan with a bank or lending institution often face a long and thorough application process.
Your income history (as evidenced by financial statements and tax returns) and cash flow matter to these lenders because they indicate how profitable your business is—and lenders believe it can be mighty hard to get their loan money back (plus interest) from a business owner who doesn’t have a record of strong income and monthly revenue. After all, why lend money to someone who can’t make the payments?
Profitability on Paper
There’s one important caveat when it comes to evaluating profitability based on tax returns. While lenders like to see profitability on tax returns, it’s possible that your business tax returns show losses even if your business is still cash flow positive.
For example, a tax return could show a loss, but when add-back items like compensation for officers of the company, interest expenses, and depreciation costs are included in calculations, cash flow can actually be positive. This is good news if you’re working with a lender that uses add-backs. But, keep in mind some lenders will not.
It’s All About The Loan
Your business’s profitability as a factor in a loan approval also depends on the type of loan product you’re interested in, says Fundera loan officer Kate Morgan. “Overall, profitability is not taken into consideration for short-term loans, asset-based loans, and lines of credit,” she says. “However, as a small business owner considers products that are more termed out—think medium-term loans and SBA loans—profitability becomes increasingly important on tax returns.”
When You Need a Loan But Your Business Isn’t Profitable (Yet)
If you’re in the market to borrow money for your business, but you’re running into roadblocks with lenders who won’t work with you because the business isn’t yet profitable, consider other options. Look at getting a different type of credit product with a traditional lending institution, like a business credit card, a short-term loan, or a business credit line. If you don’t have a profitable business but still want a term business loan, consider an asset-based lender or an alternative lender.
Learning as much as you can about issues surrounding business credit, and the criteria lenders look at when evaluating your application, helps you present the strongest case when you’re trying to borrow money for your business. It can also help you make savvier financial decisions as you work on building or improving your business credit profile.
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from Fundera Ledger https://www.fundera.com/blog/2016/01/26/why-certain-small-business-lenders-will-only-work-with-profitable-businesses/