Theory of the 3-legged stool Featured

8:00pm EDT May 22, 2006
Lenders are justifiably cautious about lending money to small companies because of the high failure rate of small businesses. To help ensure that you have the best chance of getting a loan, as well as favorable terms, the loan process should be considered a three-legged stool, says John Heck, Director of Accounting and Auditing at Kreischer Miller, a Horsham, Pa.-based accounting and consulting firm.

“The critical three questions every business owner needs to ask — and answer — before applying for a loan are: Why do I need the money? How much do I need? And how am I going to repay it?”

Smart Business spoke with Heck about how this three-legged process will help business owners create a loan application that will stand up to the scrutiny of a lender.


What does a business need to do even before considering applying for a loan?
We all know the old line: you can always get a loan if you don’t really need it. The wise thing to do is to get your house in order before you need the money; strengthen your balance sheet, increase earnings and generally build up the value of your company.


What is the first leg of the loan application process, and why is it important?
The first step is to articulate why you need the money. Is it to open up a new office or plant? Buy new equipment? Expand product lines or open a new sales territory? The reason needs to be compelling and the investment compelling, i.e., profitable. Lenders normally don’t like to fund losses, so your reason for the loan should be to grow — through expansion, new equipment, new opportunities — your already strong business. If they understand your plans for growth, lenders will take your loan application seriously. Some companies borrow money just because they can and buy new equipment without understanding the cost benefit. This first step, when the company should internally justify the investment, is an important reality check.


Once a business owner is clear about what the money will be used for, how can the owner determine how much will be enough?
This is a very important step in the process, because the loan is not open-ended.

Determining how much to borrow requires more thought and analysis than is generally given to the question. Surprisingly, many business owners request too little. They underestimate the cost of, for example, launching a new product line, which will increase marketing expenses; or moving to a bigger location, which will require capital to move and perhaps require the purchase of new equipment. In order to establish credibility with the lender, you need to think of all costs associated with your project.

Many business owners under estimate their financing needs because they are concerned about borrowing too much or they believe they may not be eligible for a higher amount. But even if you don’t run the numbers correctly, it is likely your lender will. If there is a substantial discrepancy, your chance of getting the loan is significantly reduced.


The third leg is for the business owner to ask, ‘How will I pay it back?’ How can business owners accurately make their projections?
Lenders generally require two to three years of financial history, plus three to five years of projected earnings. These projections should show the incremental benefit of the investment and how that will flow back into the repayment of the borrowings. The projections must have clear and credible assumptions presented in a logical format. A sensitivity analysis should also be prepared as part of the projections. Such an analysis will show the impact if some key assumptions vary from the basic projections.


Once these three elements are in place, what else can a business owner do?
Discuss your proposal with at least three lenders. If it is acceptable to several institutions, you are in an excellent position to negotiate the terms. Don’t think just interest rates because, while rates are important, there are many other important terms that could be negotiated to your businesses’ benefit: the length of the loan, guarantees and financial covenants, to name a few.


JOHN HECK is a director with the Accounting and Auditing Group at Kreischer Miller,, an accounting and consulting firm based in Horsham, Pa. Reach him at or (215) 441-4600, ext. 112.