The Number One Reason Banks Deny Loans to Many Small Busines…

The following excerpt is from the staff of Entrepreneur Media’s book Finance Your Business. Buy it now from Amazon | Barnes & Noble | iTunes

No one ever promised that the challenges to growing a small business would be minor. Entrepreneurs regularly confront issues that can threaten the very core of their companies, not the least of which is difficulty securing the financing they need to run and grow a sustainable business.

Finding capital is becoming harder for a significant proportion of small businesses, despite the wider variety of financing options available. Even though there are more lending alternatives for small businesses than ever before, a crucial step is missing and no one is paying attention, leaving business owners increasingly frustrated over their rejections for credit lines and loans.

The dream and the reality don’t add up — a scenario confirmed by a 2015 Nav survey of 250 small and midsize business owners, which brings to light the struggle around bank financing, small-business loans, and the rejections small businesses suffer.

The realities small businesses face

The Small Business American Dream Gap Report found that despite the positive outlook for small businesses, nearly three out of ten small businesses reported finding it harder than in the past to reduce operating costs. Nearly a quarter of small businesses, meanwhile, found it harder to plan for unforeseen expenses. Within the previous year, the survey revealed, 20 percent of the small businesses surveyed said they had considered shutting down, primarily because of lack of growth or cash-flow issues.

Those kinds of struggles had led 53 percent of those small businesses to apply for funding or credit lines over the past five years — and one in four said they had sought loans multiple times. Yet 20 percent of those applying over the past 60 months reported being turned down, and 45 percent of those denied said they’d been rejected more than once. The most frustrating finding was that nearly a fourth — 23 percent — of these businesses didn’t know why they’d been denied.

As a result, 26 percent of these business owners avoided hiring and expansion because they were frustrated with trying to access funds. Instead, they ponied up the money from their personal savings and used their credit cards to cover expenses and keep their businesses going, putting them at substantial risk.

In addition, the study determined that the last time the owners surveyed had needed funds, 62 percent had withdrawn personal savings, 22 percent had used business credit cards, 24 percent had used their personal credit cards and 10 percent had relied on family and friends. Only 36 percent of those seeking funds had obtained bank loans.

Your business credit score is the crucial missing link

The study revealed that a primary reason small businesses can’t obtain bank loans is their failure to understand their business credit score. Some 45 percent of entrepreneurs surveyed didn’t even know they had a business credit score, and 72 percent didn’t know where to find information about it. Even when they did, more than eight in ten small-business owners surveyed acknowledged that they didn’t know how to interpret their score.

Education and empowerment around creditworthiness is a core issue that can make or break a small business’s ability to get financing. Many business owners starting out are unaware of business credit and may do significant damage to their credit without realizing it — primarily by maxing-out personal credit cards and/or credit lines because they believe they have no other choice. This short-term approach can lead to significant long-term damage.

Need more information about business credit? Consider the FICO score. Just as every individual consumer has one based on his or her personal credit record, every business has one developed by the FICO LiquidCredit Small Business Scoring Service — the FICO SBSS score. Banks use this score to evaluate term loans and lines of credit up to $1 million.

The score further rank-orders small businesses by their likelihood of making on-time payments based on their personal and business credit history, along with other financial data. On a scale of 0 to 300, a small business must score at least 140 to pass the pre-screening process the SBA uses for its most popular loan — the 7(a) loan.

If a business with a poor credit history — or none at all — is denied financing, lenders are not required to notify the owner of the reason for the rejection. It’s crucial, therefore, for business owners to learn about their SBSS score and build credit with timely payments to vendors and suppliers to keep that score up. Boosting their score may take years for companies with a poor or nonexistent credit history, so the process of strengthening creditworthiness needs to begin long before they submit a credit application.

A number of business credit bureaus will generate a business credit score, including Dun & Bradstreet, Equifax, Experian and FICO. Anyone can request a business credit report from Dun & Bradstreet, Equifax or Experian, but it comes at a price. Nav offers a free service that provides access to summary reports from Dun & Bradstreet and Experian, a personal TransUnion report and alerts associated with any changes to business or personal credit.

Until recently, there was no direct way to access your FICO SBSS score, but small businesses can now get that number through Nav’s subscription service. It’s the only place small businesses can get that score online.

Why this all matters

Ultimately, those who understand business credit are better positioned to succeed. The Nav study found that nearly 40 percent of small-business owners who didn’t know their business credit score anticipated growth of less than 5 percent, while the nearly three-quarters who did know it envisioned growth of up to 20 percent.

Another answer to the perplexity surrounding rejected funding came from a revelation in the study about owners’ understanding of credit issues. The small-business owners surveyed who understood their business credit scores, the study reported, were 41 percent more likely to be approved for a business loan than those who did not. And they were 31 percent more likely to consider expanding their businesses.

Some 80 percent of those in the know about their scores, moreover, considered their funding process to have been smooth, and half of those owners indicated they were less likely to turn to personal savings to grow their companies.

Business owners, then, should determine where they stand and take control of the factors critical to the lenders, credit card companies and even other businesses they work with. When owners understand their scores, they have an easier loan approval experience and are empowered to grow and thrive and help the overall economy thrive as well. That way, everyone wins.