Many private business owners underestimate the importance of establishing strong business credit early on — and are surprised when they don’t qualify for affordable financing when they need it. Lenders are often the bearers of this bad news. Here’s a refresher on why it’s important for businesses to establish credit, what makes (or breaks) a business credit score and how borrowers can improve their ratings.
Blending debt and equity
Many private business owners underestimate the importance of establishing strong business credit from the get-go. Rather than deal with the red tape of applying for bank loans, they rely on shareholder loans or advances from family members to finance growth.
Eventually most businesses outgrow the owner’s personal resources, requiring them to apply for bank loans. But an application may be turned down or a loan issued at a higher interest rate or lower amount than the owner anticipated. The reason is simple: The owner failed to establish a separate credit history for the business.
Establishing a business credit history offers several other advantages. It helps insulate the owner’s personal assets from legal or credit claims against the business. Banks also tend to lend higher amounts at more favorable terms to businesses than individuals with similar risk profiles. And, although it’s not reported on the balance sheet, established business credit is an intangible asset that can make a borrower more attractive to potential investors.
Building credit for small businesses often starts with a corporate credit card that’s paid off monthly. But strong, established credit histories require more diverse loan portfolios that also include equipment loans, credit lines and leases.
Businesses should start small when they don’t need it and pay what’s due on time — or early. That way, when they really need bank financing, their credit history will be long established.
Learning how to play the numbers game
There are several business credit reporting agencies, such as Experian, Equifax, and Dun & Bradstreet. Each agency has its own algorithm for calculating credit scores. The higher a company’s credit score is, the lower its credit risk. Business credit starts when a borrower registers with business credit bureaus under its employer identification number (EIN).
The credit agency takes key facts from the company’s registration, including its address, phone number, owners’ names and industry classification code. The agency also searches the Internet and public records for bankruptcies, judgments and tax liens against the borrower. On an ongoing basis, creditors report payment experiences with the borrower to the credit agency.
In addition to timely bill payment, credit scores factor in:
Company size. Higher net worth or annual revenues will result in a higher credit score.
Business structure. C corporations, S corporations and limited liability companies tend to receive higher scores than sole proprietorships and partnerships.
Industry risk. Some agencies keep track of the percentage of companies under the company’s industry classification code that have filed for bankruptcy. Participation in high-risk industries lowers a business’s credit score.
Length and frequency of credit history. Companies with proven track records generally score higher than start-ups. Once a company establishes credit, it needs to use its borrowing capacity periodically — or risk being downgraded.
If you discover that your credit score has been lowered, contact the agency to find out why. In some cases, they may be willing to restore your higher score, if you can successfully prove that the downgrade is unwarranted.
Softening the blow
Sometimes lenders have to break the news that a business’s loan application has been partially or completely denied due to weak credit. An owner may be offended by your rejection, especially if the business is otherwise prospering. Savvy lenders can soften the blow by explaining how business credit scores work and offering suggestions to build and improve them.
For more information please contact a member of our lender services team at 404-874-6244.