Business loans can provide working capital at reasonable rates
One of the challenges of running a business is maintaining adequate working capital to cover basic costs.
While most businesses are not strictly seasonal, having at least some revenues coming in throughout every part of the year, the truth is that the majority of businesses experience some seasonal fluctuations in cash flow. And this variant income often requires businesses to locate sources of working capital that enable them to keep their lights on during their low tides.
New businesses may likewise need startup capital to cover expenses. Startup capital can also be obtained through standard business loan channels.
Business loans can provide needed capital
Luckily, there has never been a better time for companies to find the funds they need to keep things running smoothly.
When it comes to a working capital loan, there are four mainstream lending sources to which businesses can turn. These are bank-issued term loans, business lines of credit, invoice financing and business credit cards. Additionally, there are a few unconventional funding sources that are quickly gaining in popularity. These include peer-to-peer lending, convertible bonds and other sophisticated financial instruments.
Bank-issued term loans
The most popular option for businesses that seek a working capital loan is a bank-issued term loan.
A term loan is what most people think of when picturing what a loan is. Most familiar consumer loan types are term loans, including auto loans, mortgages and personal loans. When it comes to business, these loans function in much the same way that they would for a consumer.
Term loans will typically have a set period that will mark the total length of the loan in advance. There will be an assigned interest rate although this can be either fixed or floating. And term loans will usually follow an amortization table, which is a loan schedule that defines how much of each payment goes towards interest and principal, respectively. The loan’s amortization schedule will also determine how many payments are to be made, for how much and at what interval.
As with most retail term loans, towards the beginning of the loan period, the vast majority of payments will go towards interest. This is a way of reducing risk to the lender, allowing them to offer a lower overall interest rate than they would for a non-amortizing loan. But it also means that if the borrower defaults in the first half of the loan term, then they will typically still owe the large majority of the principal amount.
Secured versus unsecured business loans
Unlike auto loans and mortgages, some business loans may be issued on an unsecured basis. This means that there will be no underlying collateral, and the bank may not have recourse should the borrower default on the loan and then declare bankruptcy.
Unsecured business term loans are usually only offered to businesses with long histories and extremely high credit scores. Alternatively, some small businesses may qualify for an unsecured term loan if the business owner has an excellent credit score and solid credit history.
Most business term loans, however, will be secured. But unlike retail term loans that are made to consumers, businesses potentially have many sources of valuable collateral. And this means that businesses are often able to get far higher loan amounts at excellent interest rates.
Term loans for businesses can be secured against any asset that the business owns. This can include real estate, manufacturing equipment, trucks, fleet vehicles, inventory, accounts receivables and even intellectual property. A business that has millions of dollars per year in revenues will often be able to easily obtain six- or seven-figure loans through using one of the above means of collateralizing the debt.
Business lines of credit
Another great way for businesses to quickly raise operating capital is through a business line of credit.
Like business term loans, business lines of credit are normally acquired through a bank or other traditional lending institution. However, business lines of credit can offer a level of flexibility and efficiency that business term loans cannot.
Business lines of credit typically follow the same rules as term loans as far as collateral and lending requirements. If a business or its owner has excellent credit and a strong credit history, they may be able to get an unsecured line of credit. Otherwise, they will need to post some form of collateral.
However, business lines of credit only charge interest on the amount that is actually drawn. This gives business owners who may not know exactly how much money they will need a powerful option. By having up to millions of dollars available, a business line of credit gives business owners the freedom to efficiently deploy capital while not having to worry about a potentially dangerous shortfall in revenues. This can free up cash for higher-return investments, such as capital improvements or acquisitions.
An example may help to illustrate the benefits that business credit lines have over traditional loans.
Say that a manufacturing company for heavy industry has $4 million per year in revenues. But these revenues experience strong seasonal fluctuations with very high year-over-year variance. The company could have first-quarter revenues of anywhere between $0 and $2 million. It’s first-quarter costs are anticipated to be $500,000.
The company’s president has a choice. They can either take out a $500,000 term loan, which may or may not be needed. They could also set aside $500,000 in cash, which will then be unavailable for investments. Alternately, they could take out a $500,000 business line of credit, which will allow them to draw down only the money that they actually need to cover operating costs. This could mean that they may elect to draw anywhere from $0 to the full $500,000 limit.
If the company’s president takes out a term loan, they will owe interest on the entire $500,000 principal amount for the duration of the loan. They will also be putting the assets that were used to secure the loan at potential risk. If they elect to set aside the cash, assuming the company’s cashflow is sufficient to do so, then all of that money will be unavailable for investment. Considering that profitable companies often have both internal and external investment opportunities that can easily yield double-digit-and-higher returns, this is often an unattractive option.
But with the business line of credit, the company’s president gets the best of both worlds: The money is freed up for investment, and they may end up never owing a cent if the credit line turns out not to be needed.
The main drawback to going with a business line of credit versus a business term loan is that the interest rate will typically be adjustable, which can expose the borrower to significant risk, especially where most of the available credit line is used.
Business credit cards, invoice lending and other options
Business credit cards may be an option for some companies when it comes to raising short-term capital. However, like consumer credit cards, business credit cards typically charge very high rates for carrying over outstanding balances from month to month.
Generally speaking, business credit cards are best used for the purchase of daily supplies, allowing the company to take advantage of the often-enticing rewards that such cards offer. Credit cards should generally only be used as a means of funding a company’s operating capital as a last resort.
Invoice lending is another means of funding a company’s short- to medium-term operations. However, invoice funding is really just a variant of the business term loan that uses invoices as a means of securing the principal.
Finally, peer-to-peer lending, bond issues and convertible debt all offer potential ways to cover funding shortfalls. However, these debt types require a full article to be adequately treated.
Businesses that need to fund operating expenses have a wide range of options to do so. These include the popular options of both term loans and business lines of credit, either of which can be a great option for a company, depending on its individual circumstances.
Do you need a business loan to fund short- or medium-term operating costs? Check out our business lending guide today.