Demystifying Small Business Loans
New equipment, stock, raw materials, working capital, expansion and even debt consolidation are some of the most common reasons why small businesses seek funding.
For many small businesses, when looking to grow, or in challenging times, small business loans are one of the first options they will consider to help bridge the gap in their finances.
Secured and Unsecured Lending
Nowadays though, there are many different types of finance available to assist businesses throughout the various stages of their lifespan. Essentially, these are categorised into two main areas, secured and unsecured lending.
Unsecured lending means that the borrower is able to borrow the funds they need without having to use business or even personal assets as collateral. Where this presents a higher risk for lenders, interest rates are usually higher, to offset their additional risk exposure.
Secured lending, is where lenders require borrowers to use an asset as security for their loan. Meaning should the borrower default on repayments, the lender has the right to realise the value of the assets used as security, to recover their debt.
The decision whether to pursue secured or unsecured lending largely depends on the financial circumstances of the business and its owners. It is important to seek sound financial advice before making an application, in order to know what the best option is. Too many failed applications for credit can have a negative impact on the business’ credit score, much like with personal credit ratings.
Types of loan finance for small business
Within the broader categories of secured and unsecured lending, businesses can take advantage of an ever-increasing range of financial instruments. Here are a few examples:
Term Loans, as the name suggests, are loans that businesses can repay over a fixed period of time, that can be anywhere between one to five years for example. Typically, a fixed rate of interest is agreed for the duration of the loan agreement.
Available via banks and alternative finance providers, interest rates vary from lender and will often depend on current base rates, the business’ past and present performance, its credit history and that of the business owner/s.
Some of the main advantages of a term loan are that they offer businesses greater flexibility in terms of how funds are spent. If repayments are made on time, they can also help to build the business’ credit rating and may even offer some tax advantages.
In contrast, some of the main disadvantages of a term loan include, the need to use high value assets as collateral when seeking secured finance. In instances where the business or its owner does not have any tangible assets, and is therefore looking to obtain an unsecured loan, a higher interest rate is applied to offset the greater risk exposure for the lender.
Another key disadvantage is that the larger the loan is, is the higher the monthly repayments will be. Whilst initially it may seem advantageous to obtain a loan to assist with expansion, as the loan is likely to take some time to repay, business owners need some degree of certainty and assurance that they will be able to meet the repayment terms over the full duration of the loan agreement.
Failure to meet repayments on time can result in loss of assets (insofar as secured loans are concerned) or in very extreme cases liquidation.
That being said, there are also some very distinctive differences between loans offered by more traditional banks in comparison to alternative finance providers.
Traditional bank loans
Considered by some to be one of the most desirable forms of loan finance, due to lower interest rates, traditional bank loans can be notoriously difficult for many small businesses to obtain. Usually, a pristine credit rating and strong trading history are required to do so successfully.
Businesses that are just starting out, or those that have faced more strenuous financial challenges, are often ruled out of the equation when it comes to this type of debt finance. As they are often unlikely to meet with lending criteria.
For those that do, this type of loan finance can be advantageous due to lower interest rates.
Unlike alternative finance providers, a traditional bank loan is a lengthier process and there is likely to be more paperwork involved. This can be a hindrance to businesses that require cash quickly to buy property, equipment or raw materials, so that they can start to fulfil a new contract for example.
Alternative Finance Providers
Since the turn of the millennium there has been a significant rise in the number and nature of alternative finance providers.
For businesses seeking loan finance it can be difficult to know who to choose and in such it’s advisable to seek professional advice.
One of the main advantages of using an alternative finance provider is that they can offer finance to businesses who are typically unable to do so through traditional banks and lending institutions.
The application process tends to be more simplistic in nature, and the decision process a lot faster, with some lenders able to make a decision within 48 hours.
Whilst this can be a crucial lifeline for businesses seeking fast cash, it is also important to note that in general, interest rates tend to be higher than those charged by traditional lenders. In such, businesses need to consider the impact this will have on finances, especially in the long-term, where they will be required to maintain regular monthly repayments.
Professional advice can be beneficial in understanding whether a loan is really the best option for their business requirements, as opposed to other forms of debt finance.
Other types small business loans include:
Cash Advance Loans
A business cash advance loan is a type of unsecured lending, where businesses borrow against future sales income. Borrowers apply for a fixed loan amount and repay their debt through future credit or debit card sales.
Some of the main advantages of cash advance loans, is that loan agreements can take less time to set up in comparison to more traditional forms of lending.
Businesses do not necessarily need to have an excellent credit history to obtain a cash advance loan.
The amount repayable is established during the application process, this is unlikely to change throughout the duration of the agreement.
Businesses make repayments as a daily percentage of credit or debit card transactions. So, in months where sales are slower than usual, repayments are naturally lower due to the actual sales generated, as opposed to a fixed monthly repayment amount. This also helps to mitigate the risk of late repayment fees or penalties.
In contrast, some of the disadvantages include the fact that cash advance loans are considered to be one of the most expensive forms of borrowing, and in such should only be considered as a short-term finance solution.
While the principle of making repayments based on daily sales can sound appealing, it’s important to note that this can also restrict cash flow. Then there’s the added risk of borrowing against future sales, which in even in the best of circumstances, can be difficult to predict.
Revolving Credit Facilities
Revolving credit facilities operate in a similar way to bank overdrafts and credit cards, whereby borrowers can apply for a line of credit up to an agreed sum. This allows business owners the flexibility of withdrawing sums up to the agreed credit limit, making repayments and then make more withdrawals, as and when extra cash is required.
Rates of interest can be either fixed or variable depending on the lender in question and duration of the credit agreement. Where longer-term agreements are in place, the revolving credit facility is likely to have a variable interest rate attached, which is usually set in relation to the current base rate which fluctuates.
Revolving credit facilities can be secured against assets such as equipment, stock or property which in turn helps to reduce the level of interest applied.
The main benefits are that they can be a source of essential working capital, at times when seasonality negatively affects income, or when unexpected expenses occur and extra cash is required.
The main disadvantages of revolving credit facilities are that they attract higher interest rates, and will often involve a smaller amount than a traditional term loan for example. Borrowers also have to pay a commitment fee for the convenience of having the facility in place, even when there is no balance outstanding.
Due to the higher interest rates and commitment fees associated with revolving credit facilities, they are at best most suitable as a short-term finance solution.
Making the right decision
Even for more experienced business owners, making the decision as to which type of finance best suits their business needs can be daunting. Past and present business performance plays a major role in what types of finance they will have access to, whether or not security is required to secure loan finance, and the interest rates that will be applied.
Most forms of finance for business with the exception of non-repayable business grants will come at a cost to the business. This must be taken into consideration before the start of any loan agreement.
Business owners also need to evaluate the longer-term implications that loan repayments will have on day-to-day, monthly and yearly cash flow.
In many instances, businesses may require more than one type of loan or credit facility in place in order to grow.
For these reasons, the decision to enter into a credit agreement should not be taken lightly.
We strongly recommend that business owners seek independent professional financial advice to identify which lending options best accommodate their needs.
To find out more about finance options for small business you can also read our Guide to Business Finance. Or find out more about our funding solutions here.