A loan is the purchase of the present use of money with the promise to repay the amount in the future according to a pre-arranged schedule and at a specified rate of interest. Loan contracts formally spell out the terms and obligations between the lender and borrower. Loans are by far the most common type of debt financing used by small businesses. Loans can be classified as long-term (with a maturity longer than one year), short-term (with a maturity shorter than two years), or a credit line (for more immediate borrowing needs). They can be endorsed by co-signers, guaranteed by the government, or secured by collateral—such as real estate, accounts receivable, inventory, savings, life insurance, stocks and bonds, or the item purchased with the loan. The interest rate charged on the borrowed funds reflects the level of risk that the lender undertakes by providing the money. For example, a lender might charge a startup company a higher interest rate than it would a company that had shown a profit for several years.
Characteristics of Loans
Loans have the following distinguishing characteristics:
- Time to maturity. Time to maturity describes the length of the loan contract. Loans are classified according to their maturity into short-term debt, intermediate-term debt, and long-term debt. Revolving credit and perpetual debt have no fixed date for retirement. Banks provide revolving credit through extension of a line of credit. Brokerage firms supply margin credit for qualified customers on certain securities. In these cases, the borrower constantly turns over the line of credit by paying it down and reborrowing the funds when needed. A perpetual loan requires only regular interest payments. The borrower, who usually issued such debt through a registered offering, determines the timing of the debt retirement.
- Repayment Schedule. Payments may be required at the end of the contract or at set intervals, usually on a monthly or semi-annual basis. The payment is generally comprised of two parts: a portion of the outstanding principal and the interest costs. With the passage of time, the principal amount of the loan is amortized, or repaid little by little until it is completely retired. As the principal balance diminishes, the interest on the remaining balance also declines. Interest-only loans do not pay down the principal. The borrower pays interest on the principal loan amount and is expected to retire the principal at the end of the contract through a balloon payment or through refinancing.
- Interest. Interest is the cost of borrowing money. The interest rate charged by lending institutions must be sufficient to cover operating costs, administrative costs, and an acceptable rate of return. Interest rates may be fixed for the term of the loan, or adjusted to reflect changing market conditions. A credit contract may adjust rates daily, annually, or at intervals of 3, 5, and 10 years. Floating rates are tied to some market index and are adjusted regularly.
- Security. Assets pledged as security against loan loss are known as collateral. Credit backed by collateral is secured. In many cases, the asset purchased by the loan often serves as the only collateral. In other cases the borrower puts other assets, including cash, aside as collateral. Real estate or land collateralize mortgages. Unsecured debt relies on the earning power of the borrower.
Common Types of Loans
Consumers and small businesses obtain loans with varying maturity periods to fund purchases of real estate, transportation, equipment, supplies, and a vast array of other needs. According to W. Keith Schilit in The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital, they receive these loans from a number of sources, including friends and relatives, banks, credit unions, finance companies, insurance companies, leasing companies, and trade credit. The state and federal governments sponsor a number of loan programs to support small businesses. Following are examples of some common types of loans.
SHORT-TERM LOANS. A special commitment loan is a single-purpose loan with a maturity of less than one year. Its purpose is to cover cash shortages resulting from a one-time increase in current assets, such as a special inventory purchase, an unexpected increase in accounts receivable, or a need for interim financing. Trade credit is another type of short-term loan. It is extended by a vendor who allows the purchaser up to three months to settle a bill. In the past it was common practice for vendors to discount trade bills by one or two percentage points as an incentive for quick payment.
A seasonal line of credit of less than one year may be used to finance inventory purchases or production. The successful sale of inventory repays the line of credit. A permanent working capital loan provides a business with financing from one to five years during times when cash flow from earnings does not coincide with the timing or volume of expenditures. Creditors expect future earnings to be sufficient to retire the loan.
INTERMEDIATE-TERM LOANS. Term loans finance the purchase of furniture, fixtures, vehicles, and plant and office equipment. Maturity generally runs more than one year but less than five. Consumer loans for autos, boats, and home repairs and remodeling are also of intermediate term.
LONG-TERM LOANS. Mortgage loans are used to purchase real estate and are secured by the asset itself. Mortgages generally run between ten and forty years. A bond is a contract held in trust with the obligation of repayment. An indenture is a legal document specifying the terms of a bond issue, including the principal, maturity date, interest rates, any qualifications and duties of the trustees, and the rights and obligations of the issuers and holders. Corporations and government entities issue bonds in a form attractive to both public and private investors. A debenture bond is unsecured, while a mortgage bond holds specific property in lien. A bond may contain safety measures to provide for repayment.
Loan Considerations for Small Businesses
When evaluating a small business for a loan, Jennifer Lindsey wrote in The Entrepreneur's Guide to Capital, lenders ideally like to see a two-year operating history, a stable management group, a desirable niche in the industry, a growth in market share, a strong cash flow, and an ability to obtain short-term financing from other sources as a supplement to the loan. Most lenders will require a small business owner to prepare a loan proposal or complete a loan application. The package of materials provided to a potential lender should include a comprehensive business plan, plus detailed company and personal financial statements. The lender will then evaluate the loan request by considering a variety of factors. For example, the lender will examine the small business's credit rating and look for evidence of its ability to repay the loan, in the form of past earnings or income projections. The lender will also inquire into the amount of equity in the business, as well as whether management has sufficient experience and competence to run the business effectively. Finally, the lender will try to ascertain whether the small business can provide a reasonable amount of collateral to secure the loan.
Experts indicate that borrowing can be a useful strategy, particularly for companies with good credit and a stable history of revenues, earnings, and cash flow. But small business owners should think carefully before committing to large loans in order to avoid cash flow problems and reduced flexibility. In general, a combination of loans and other types of financing is considered most desirable for small businesses.
In the Small Business Administration publication Financing for the Small Business, Brian Hamilton listed several factors entrepreneurs should consider when choosing between their various financing options. First, the entrepreneur must consider how much ownership and control he or she is willing to give up, not only at present but also in future financing rounds. Allowing the founders to retain ownership and control of the company is a major advantage of loans over equity financing, or selling stock to outside investors. Second, the entrepreneur should decide how leveraged the company can comfortably be, or its optimal ratio of debt to equity. Third, the entrepreneur should determine what types of financing are available to the company, given its stage of development and capital needs, and compare the costs and requirements of the different types. Finally, as a practical consideration, the entrepreneur should ascertain whether or not the company is in a position to make set monthly payments on a loan.
No matter what type of financing is chosen, careful planning is necessary to secure it. The entrepreneur should assess the business's financial needs, and then estimate what percentage of the total funds must be obtained from outside sources. A formal business plan, complete with cash flow projections, is an important tool in both planning for and obtaining financing. Lindsey noted that small businesses should consider loans as a financing option when federal interest rates are low, they have a good credit history or property to use as collateral, and they expect future growth in earnings as well as in the overall industry.
The main disadvantage of loans is that they require a small business to make regular monthly payments of principal and interest. Very young companies often experience shortages in cash flow that may make such regular payments difficult. Most lenders provide severe penalties for late or missed payments, which may include charging late fees, taking possession of collateral, or calling the loan due early. Failure to make payments on a loan, even temporarily, can adversely affect a small business's credit rating and its ability to obtain future financing. Another disadvantage associated with loans is that their availability is often limited to established businesses. Since lenders primarily seek security for their funds, it can be difficult for unproven businesses to obtain loans. Finally, the amount of money small businesses may be able to obtain via loans is likely to be limited, so they may need to use other sources of financing as well.
Further Reading:
Anderson, Tom. "Choosing a Corporate Bank for Business Loan, Partnership." Memphis Business Journal. November 3, 2000.
Evanson, David R. "B-B-Bad to the Loan." Entrepreneur. February 2000.
Hamilton, Brian. Financing for the Small Business. U.S. Small Business Administration, 1990.
Heath, Gibson. Doing Business with Banks: A Common Sense Guide for Small Business Borrowers. DBA/USA Press, 1991.
Lindsey, Jennifer. The Entrepreneur's Guide to Capital. Probus, 1986.
"Make Preparations Before Approaching Bank for Your Loan." Memphis Business Journal. November 3, 2000.
Schilit, W. Keith. The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital. Prentice Hall, 1990.
Timmons, Jeffrey A. Planning and Financing the New Venture. Brick House Publishing Company, 1990.
Hammond, Bob. Life After Debt: Free Yourself from the Burden of Money Worries Once and for All. Franklin, N.J.: Career Press, 2000.
