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Why are Loans Important?
Any business will require a reliable stream of funds to operate profitably. More often than not, relying only on retained earnings and profits for furthering of business is not a good idea. This is for a number of reasons.
- the firm will not be able to pass on the benefits of leverage to shareholders,
- significant blockage of funds in capital expenses will prevent cash flow for operational purposes,
- no drawing capability for promoters/owners,
- inability to accumulate sufficient funds in times of emergency to name a few.
In such cases, only an external inflow of funds can help relieve the situation. Loans or credit are thus the lifeblood of any business. A business may be very successful. However, in order to sustain and grow, it must make the best use of borrowed funds.
Types of Business Loan
A universe of borrowing options has emerged with the rapid development of capital markets in the recent past. A wide array of loan options is now available. The credit experience can now be tailor-made to suit the specific need of individual businesses. Let us now discuss some of the most prevalent types of business loans.
These loans are granted by the Small Business Administration (SBA) to budding businesses and upcoming entrepreneurs. SBA is a United States government agency that has undertaken to support the growth of a self-sufficient economy in the United States. The SBA plays the role of the guarantor in securing loan amounts up to $150,000 by 85% and by 75% in excess of $150,000. A federal agency is present as a guarantor in this situation. This encourages the banks to participate and extend credit.
- Advantage: Designed to accommodate lower down payments and longer repayment terms.
- Disadvantage: The process of obtaining SBA finance is more arduous than conventional finance. Attachment of personal property of the borrower in case of default is always a risk.
Line of Credit (LOC)
It is an arrangement by a financial institution, typically a bank, whereby a particular loan amount is sanctioned to the account of the borrower. The latter withdraws the balance as and when required. However, the beauty of this mechanism is that the interest is chargeable only on the amount actually used. LOC is also known as the revolving credit. One can go on using the credit line if one replenishes the balance as he uses. Thus, the same account keeps on rolling over and over again.
- Advantage: It is usually an unsecured form of advance and therefore the assets remain mortgage free. Also, the rate of interest is much less than that on other short-term credit options.
- Disadvantage: Line of credits have stringent qualification requirements. Only firms with good trading history, a satisfactory asset base, and a decent credit score can secure credit lines.
Most simply put, invoice factoring means selling of your receivables to a factoring company for immediate cash. Any business involves an operating cycle. Therefore, there always exists a gap between the sales of goods to the actual receipt of payment. This may vary from 30 to 90 days or even more. Such cash crunches, even though temporary, can bring the smooth operations to a halt.
Invoice factoring is a type of business loan where the receivables are sold to a factor for an immediate release of funds. The firm ends up losing complete control over its receivables. The factoring company is then responsible to ensure collection of dues from the customers. The factor after deducting a margin furnishes instant balance to the firm. The deduction is usually an equivalent of the interest that would be chargeable on the amount extended at the prevailing rates.
- Advantages: Enables the company to improve its liquidity and carry on the operations without any hiccups. The application and approval process is also much smoother than other conventional options.
- Disadvantages: The customers are intimated of such arrangements via a Notice of Assignment. This may taint the trust and fiduciary relationship between the firm and its customers. An alternative to factoring is invoice financing. Like factoring, financing also facilitates immediate release of funds. However, the firm retains control over the receivables. Therefore the customers remain unaware of any such arrangement.
As the name suggests, equipment loans are a type of business loan to purchase business equipment. Such loans are usually secured by the underlying equipment itself. These loans have a duration that coincides with the life of such equipment. Such financing has greatly benefited certain industries such as manufacturing, construction, healthcare, restaurant, IT etc which are mainly capital intensive.
- Advantage: The liability does not exceed the value of the asset pledged. In case of default, the lenders can seize the equipment financed. It prevents attachment of personal property such as the house or other business assets of the borrower. The firm can also reap the benefits of tax shields on the interest payment.
- Disadvantage: Credit rating plays a crucial role. Firms with poor ratings or start up’s and newer businesses shall have to bear the burden of hefty down payments due to unsatisfactory ratings. The interest rates and terms of the loan may also be stringent depending on the credit score.
This is a type of business loan, extended in very small amounts to new businesses or not-for-profit organizations. These businesses particularly operate in the third world countries. Upcoming businesses in smaller economies are not able to provide an attractive credit score, collateral, and fancy future projections. Thus microloans or micro-credit come into the picture where finance is provided by a pool of individuals or community-based lenders rather than banks. The loan is for minuscule amounts not exceeding $50,000. The goal is to cover the flotation and incorporation expenses of budding ventures in underprivileged countries.
- Advantages: Micro-lenders often act as mentors and provide valuable technological and intellectual know how to borrowers. This serves as a boon to business owners who work in challenging environments.
- Disadvantages: Microloans entail inflated interest rates. Though the rates are lower than on credit cards, they are still higher than traditional borrowing options. The rationale for this may lie in the fact that since this is an unsecured form of loan, the lenders seek to compensate themselves via an increased interest rate.1,2