To better understand capital, and its role in the 504 Loan Program, we must first explore the relationship between risk and return. This relationship is a fundamental idea in finance. Investors risk their money when buying stocks, on the chance of a reward in dividends. Lenders take a risk when loaning money to a business. The return on their risk is the interest paid on the loan.
How, then, do banks minimize their risk when issuing loans? Lenders want assurances that a borrower will be capable of repaying the principal and the interest on a loan. The greater the assurance, the lower the risk. Warren Buffett coined the phrase "skin in the game" to refer to a situation where business owners invest their own money in the company. The best vote of confidence is putting one's own money on the line just like the lender. The money an owner puts into his or her own company is called capital.
Lenders expect an owner to undertake personal financial risk before asking them to take one. Capital is an indication of how much an owner risks losing should the business fail. Banks believe that if you have a significant personal investment in your company, you are more likely to do everything in your power to make the business successful, and thus are more likely to repay the loan.
Banks aren't really interested in owning your property or your company. They would rather you work through any unforeseen troubles and keep the business working towards a turnaround. This is why sufficient skin in the game, or capital, is so important.
There is no exact measure of "enough capital," as every lending situation is unique. Lenders will consider a company's debt-to-equity ratio to compare how much is being borrowed (debt) to how much the owner has invested (equity). There must be sufficient equity to cover a company's debts, even if the company has an interruption in its cash flow.
A low debt-to-equity ratio (below .30) is considered good because it indicates the company has a low amount of debt. A high ratio (2 or greater) can be troublesome because it indicates a greater amount of debt compared to equity.
However, lenders look carefully at the amount and quality of capital the owner has to offer, because different industries demand different financial frameworks. Some industries need large investments in fixed assets, while others need large amounts of liquidity to meet operating expenses. High operating income allows even a debt-burdened company to meet its obligations.
As stated previously, every lending situation is unique because every company's financial situation is unique. Community Business Finance understands this and has the experience in the 504 Loan Program to accurately assess your capital.
Community Business Finance wants to finance your business dream with its 504 Loan Program.
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In Texas call Bill Ebersole at 713-457-1650, ext. 201, or email him at firstname.lastname@example.org.
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