How Does Business Credit Work? This Is How Lenders Decide
How business credit works is a mystery to many company owners. However, the process behind it is actually quite simple and straightforward. Whenever you apply for commercial finance, the lender you approach will almost certainly order a business credit report as part of their decision-making process.
That report contains important accounting data on how well your business manages money. It shows how much your company owes on any current loans, credit cards, and overdrafts, and to your suppliers. It also records if and how often your firm fails to pay its bills on time, and in full.
Although your credit history is not the only factor lenders consider when assessing an application, it’s an important way for them to determine how likely you are to miss repayments or default on a commercial finance agreement.
In this article, we describe in detail how business credit works. Read on to discover what business credit is, how lenders decide which applications to improve, and what you can do to improve your business credit rating.
How Does Business Credit Work?
Business credit is capital that your company can access from its suppliers and lenders.
Suppliers often grant businesses credit accounts. This allows you to purchase goods and services and not have to pay for them for 30 days, 60 days, or longer. This gives you the chance to sell those goods and services to your customers before you have to settle the invoice.
Lenders extend commercial credit in multiple ways, including equipment financing, a bridge loan, a merchant cash advance, or a small business loan.
How Lenders and Suppliers Handle Finance Applications
The decision-making process that lenders and suppliers use to approve applications is a key part of how business credit works.
They want to de-risk lending as much as possible to minimize their chances of losing money. When assessing your request, lenders and suppliers take into account both their credit criteria and your creditworthiness.
Credit Criteria
Credit criteria are the rules lenders set for deciding whether to approve an application for business lending. In other words, no matter how good your credit history, you have to meet these conditions first.
Factors that lenders often consider include:
Business experience: Many financial institutions want borrowers to have a track record in business. That’s why so many new businesses and startups find accessing finance particularly difficult.
Cash flow: Lenders want to see that your business generates enough surplus capital so that you can not only make your repayments on the capital they advance to you but also pay for your general business expenses and any other finance facilities you have.
Profitability levels: If you want to borrow to expand your business, lenders often need to know your current annual revenue and your level of profitability. Companies with low margins tend to fall into trouble faster if they’re hit by a downturn in sales or a series of unexpected bills, as it’s harder for them to build up cash reserves.
Collateral: To reduce their risk of loss, some lenders require borrowers to provide collateral like real estate and accounts receivables. This reduces lender risk of loss because, if your company defaults, they can sell your collateral to raise funds to pay off your outstanding balance.
Personal credit history: Many lenders also require a personal guarantee to reduce their exposure to risk. If your firm defaults, they’ll chase you and other directors to pay off the debt. So when reviewing your application, they’ll also take into account your current personal credit score and may wish to review your personal assets to check that you can personally repay them if your business can’t.
Creditworthiness
Your supplier or lender will also check your business credit report to find out your track record to date in making on-time payments to your suppliers, other lenders, and the IRS.
They order the report from one of the three main business credit bureaus:
Experian: Experian’s Intelliscore Plus system ranks businesses based on information the bureau holds on the company, its owners, and its payment trends, as well as data from public record filings. As with Experian’s personal credit reports, the score that companies receive ranges from 300 to 850.
Equifax: An Equifax business credit profile contains a company’s contact details; a summary of its current active credit accounts; information held about it on the public record (like liens, bankruptcies, and judgments); its recent payment trends; and risk scores.
Dun & Bradstreet: Companies are given a Paydex score between 1 and 100, based on how likely they are to pay their debts on time. To gather this information, Dun & Bradstreet collects data from up to 875 different partner businesses on payment timings and whether particular accounts have been sent to collection agencies.
Coming to a Decision
Lenders and suppliers now know how well you manage money and if you meet their minimum credit criteria.
If you have a strong credit history and your company fits the profile of the type a lender or supplier is happy to work with, your application is more likely to be approved. The stronger your application, the lower interest rates you’ll pay.
If you fail to meet a lender’s or supplier’s credit criteria, have a less-than-perfect credit history, or both, your application may be declined or you may be offered another option.
4 Steps to Building and Maintaining a Strong Business Credit Rating
Take the following four steps to build business credit for your business so that you improve your chances of being approved for finance on better terms.
1. Register Your Business as a Separate Entity
Setting up in business as a sole proprietor or unincorporated partnership is quick and easy. However, you need to do it the right way because if you don’t, it’ll be harder for your company to establish its own distinct business credit history.
There are two important reasons why it’s important for lenders and suppliers to see your company as a distinct business entity.
First, your company gets its own business credit report. There’s no cross-contamination with the credit reports of you and other shareholders. So if adverse information is posted to your personal credit report or to a fellow shareholder’s, it won’t appear on your business report.
Second, suppliers and lenders can see your true business performance. They’ll make a judgment on your application based on metrics like your actual cash flow and profitability. This could lead to lower interest rates and a greater chance of approval when you apply for credit.
There is another benefit unrelated to business credit status. If you pay for goods or services on your personal credit card, you’ll have to transfer the cash from your business accounts for bookkeeping purposes. By paying for goods and services from your business, it makes your accounting easier.
So that lenders, suppliers, and credit bureaus can separate you as a person from your business, consider:
Giving your company a distinct name: Your business name is your company’s unique identity that the outside world sees, so select a name that is easily identifiable and reflects who you are and what you do.
Choosing a business structure: Speak to your accountant and lawyer about the legal setup of your business. You’ll have a number of choices like a sole proprietorship or a limited liability company (LLC). The choice you make will have tax and other implications, so make sure you select the right setup for your business.
Getting a business address: Use your business address in all communications with lenders, suppliers, and the IRS. You can choose your home address as your business address if you want, but keep in mind that having a home address instead of a brick-and-mortar location may affect access to funding sources.
Setting up a business phone line: Another great way to establish an identity and a presence for your company that’s unique from yours is a dedicated business phone number registered to your legal name. If you don’t want to answer the phone yourself, you could engage a virtual answering service to pick up calls for you.
Opening a business bank account and credit card: Use your business checking account to make and receive payments instead of your personal account. Likewise, use a business credit card to buy goods and services for your firm instead of a personal credit card.
Getting a D-U-N-S number: Dun & Bradstreet is one of the major credit agencies, and they issue D-U-N-S numbers that tie businesses to a specific physical address.
Contacting the IRS: Ask the IRS to issue you a Federal Employer Identification Number (FEIN) — this is like a business Social Security number. Many lenders require you to provide your FEIN when you apply for a facility.
2. Start Building Your Credit History
Now that your company has its own identity and bank account, you need to take steps to populate your business credit report with relevant data. This gives credit bureaus and lenders the information they need to decide how well you manage your company’s finances.
Three positive actions you can take are:
Asking for supplier credit accounts: Many suppliers offer credit accounts to their customers so they can delay paying for inventory. Prioritize setting up accounts that report payments back to credit bureaus, as this will build up your history.
Finding trade referees: Dun & Bradstreet (D&B) allows your suppliers to share your payment history with them so they have additional sources of data to assess your credit rating. D&B lists the types of companies you can select on their website. Bear in mind that if you miss a payment, this will negatively impact your report.
Not overapplying for new facilities: If you apply too often for small business loans and other types of credit, this will be reflected in your score and can make lenders more reluctant to work with you.
3. Manage Your Credit Accounts Well
Over time, your credit score will build if you stick to these five important rules:
Meet all your payments: Make sure that you make every payment on time and in full to every lender you owe money to, from your small business loan provider to your credit card issuer. Remember that every payment you miss is recorded in your credit report.
Pay your taxes on time: You need to ensure that you have enough money set aside to pay state and federal taxes when they come due. If you don’t, this may greatly impact your ability to apply for new credit lines in the future.
Settle all supplier bills: Many of your suppliers, especially the larger ones, may report on client financial behavior to credit bureaus as a matter of course. Paying your suppliers on time ensures you maintain a healthy relationship with them, and may lead to an increase in your credit limit with them over time.
Keep credit utilization low: Credit utilization is a measure of how reliant you are on particular credit accounts. For example, if your business card limit is $25,000 and you always run your balance close to your limit, your utilization rate is high. This may suggest that you’re reliant on debt to stay in business and may make further borrowing harder to obtain.
Don’t forget your personal finances: Some lenders check consumer credit records as part of their decision-making process. This means that you should be as disciplined with your personal debts as you are with your company debts.
4. Monitor Your Business Credit File
Check your business credit reports regularly to make sure that the information on them is correct. (Be aware that all three bureaus charge for this service.) Credit bureau records are not infallible, and they may contain mistakes as well as fraudulent activity. If you spot a mistake, you can contact the relevant bureau to request a correction.
The Benefits of Having a Good Business Credit Score
There are significant upsides to having a good business credit rating, which include:
Easier access to capital: Because you’re seen as a lower risk, more lenders will be willing to work with you to meet your business expenses, fund expansion, and more.
Lower interest rates: When you need to borrow money, the cost of your loan repayments will be more manageable thanks to the lower rates lenders will charge you.
Better negotiating power: A great credit history will make it easier to secure higher limits from lenders and suppliers, freeing up your cash flow.
Cheaper insurance policies: Companies with high credit scores often pay lower insurance premiums.
Stay on Top of Your Business Finances to Build Your Creditworthiness
Typically, a business needs between 12 months and 18 months to build up a strong credit rating. This is just how business credit works. You need to give it time and also keep a constant eye on the information that business credit reporting agencies hold about you to make sure that it’s accurate.
It’s worth it, though. Establishing business credit is key for any company that wants easier access to commercial finance to meet its everyday expenses or fund expansion. Start by ensuring that there’s a clear distinction between you and your company. Then pay your bills on time, and don’t max out your current credit limits. This will help you increase your score incrementally.
Backd provides the following competitive financial products to companies with FICO scores of 625 or more:
Business line of credit: Borrow up to $750,000 with weekly repayments over six or 12 months.
Working capital advance: Access up to $2 million with a flexible repayment schedule over a term of up to 16 months.
Apply today, and be funded as soon as tomorrow.
