In August 2021, we participated in a panel discussion alongside Giulianna Crivello, Head of Ventures at Draper Startup House, and Mahesh Niruttan, Chief Executive Officer of 20Cube Logistics. During the session, we touched on how companies can find a balance when raising debt and or equity, and how the space will evolve in the future. In this post, I would also like to touch on in greater detail how credit is evaluated by lenders.
Consider this scenario, your friend has reached out to you asking to borrow $100,000 over 12 months. How would you evaluate this request, and what would be your response to her?
In the next section, we will identify the potential questions we can ask during credit evaluation.
Purpose of funds:
What will the funds be used for? ( Always seek for borrower to disclose purpose of funds during credit evaluation)
It is important to make known to lenders how the funds are going to be utilized. The last thing lenders would want is for your friends to use the money for inappropriate purchases such as vices. Money should be going toward revenue generating activities. This provides lenders with comfort that the loan can be fully repaid at the end of maturity.
In this instance, the use of funds will go toward starting a Food and Beverage business (F&B) selling pastries. In addition, the funds will be used for hiring of manpower, and rental of the premise.
Source of repayment:
Since the tenor of the working capital loan will stretch for 12 months, how will the borrower pay off the loan monthly? What are the sources of funds?
Ask for financial forecast:
- What would you expect sales to be for the next 12 months?
- When do you expect to be profitable?
Consider the following (worst case) scenarios:
- How will the pandemic affect the business? How does she plan to overcome these obstacles?
- If the business does not perform as expected, how is she going to continue with the payments?
- What was her salary before, and does she have enough savings to repay in a worst-case scenario or black swan event?
What are the company’s current debt obligations? (This significantly impacts the credit evaluation process)
Usually, newly set up companies have little to no debt acquired on their balance sheet. However, if the company has been in operations, you might want to examine their past financial figures. This helps lenders understand the existing debt commitments undertaken by the company in their credit evaluation process.
Existing commitments have a direct impact on the repayment ability. When the amount of monthly dues exceed the companies inflows, the company’s repayment ability will erode.
The above are some factors that lenders take into consideration when making a lending decision. As a result, it is always helpful to have these information prepared beforehand to help funders process your application quickly. This speeds up the application process, allowing you to capture business opportunities that are time sensitive and propel your business to the next level.