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How Lenders Evaluate Time In Business

Statistics show that 50% of businesses fail before reaching the five-year mark. Traditional banks are risk averse and typically err on the side of caution, avoiding loans to businesses less than five years old. In the eyes of a lender, young companies are categorized as high risk for the following reasons.

Credit Profile is too “Thin”

The longer a company is in business, the more financial data lenders have to evaluate. A company with a thin credit profile means that lenders lack adequate data to qualify the business for a loan.

Lenders with limited data are less confident in their financial projections, delinquency ratings, and stress scores. It is also difficult to examine a young business’s ability to manage expenses, generate revenue, and repay loan obligations over an extended period of time.

Companies with shorter track records are labeled high risk until lenders have enough data to accurately access the company’s financial capacity to acquire new debt.

Period of Instability

Young companies are more likely to experience periods of instability. Variations in product demand, scale of production, cost per unit sold, and startup cost can lead to swings in profitability.

Banks like to see consistent profit margins and categorize fluctuating profitability as high risk. Matured companies are more likely to demonstrate consistent profitability to pay back debt.

Evidence of Survivability

Banks also like to evaluate whether the company and the market for the product/service show strong survivability. Since banks offer long-term lengths, they want to make sure the market and business will not dissolve before the debt is repaid.

After five years, companies usually have matured out of the startup phase, sales/expenses have stabilized, and the market has continually shown strong demand.

Conclusion

Because most new companies will fail before reaching 5 years in business, banks prefer lending to matured companies. However, that does not mean that banks refuse to lend to young companies.

 

 

SOURCE: KALAMATA CAPITAL



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