In this educative article we will be discussing another major business financing option; which is debt financing.
What is debt financing?
Debt financing simply means raising capital for your business by taking loans. When you borrow a certain amount of money to start or expand your business, and this money has to be paid back along with interest within a specified period of time, what you have taken is a loan.
What makes a loan different from the equity funding options explained in previous chapters is that the lender does not hold shares in your business. Rather, the lender’s reward for helping your business is the interest that you will pay back along with the loan.
Loans have a language of their own. Being the one borrowing the money, you (or your business) are the borrower or debtor. The bank or other source of the loan is the lender or creditor. The specified period you have to pay back the loan alongside the accompanying interest is the term or period of the loan, or the loan’s maturity. And the amount you borrowed from the lender is the principal.
There are two types of loans, based on the sources you obtained them from:
- A commercial loan is one you obtain from a private institution such as a bank or a government-owned loan agency, such as the Small Business Administration, or SBA (in the U.S.)
- A private loan, on the other hand is one you obtain from your best friend, your uncle, or your father-in-law.
In both cases, the basic rule applies. That is, you will pay back the loan within a specified period along with some interest, which may vary from lender to lender. Loans can also be classified based on how they are released to you—into two main types:
- A lump-sum loan, where you get all the money you need at once and then repay it.
- A line of credit, where you are only allowed to use up the funds gradually until you reach a certain limit. (For example, if you receive a $10,000 line of credit, you can take $4,000 initially and reserve the rest for another time).
Obviously, your first line of defense when you need to take a loan for your business is to approach your relatives and friends. It could be a wealthy cousin or a well-connected father-in-law. Getting a loan from these people is always very easy, and they won’t demand crippling interests.
Only when you cannot get loans from your close ones should you consider taking a commercial loan, because they involve lots of formality and protocol. Two forms of loans will be our focus in this chapter:
3 Reasons Why You Probably Need a Loan for your Business
“Business is all about risk. If you want to be rich, you must take risk, either with your money or with borrowed money. In all, take risk.” – J. Paul Getty
In the world of business, entrepreneurs are constantly in the game of raising capital. Some entrepreneurs, especially small business owners, avoid going into debt. There is nothing wrong with borrowing funds for your business provided the money will be used to solve the problem it was borrowed for. Without wasting much of your time, i want to share with you 3 reasons why entrepreneurs borrow money for their business.
- For Normal Business Operation-: Sometimes in business, the initial capital raised, which includes the entrepreneur’s money will not be enough to cover the basic expenses of the business. Most of the money raised will be tied down in assets such as machinery, operational facilities and inventory. So an entrepreneur may resort to borrowing short terms loans to cover operational expenses such as payroll, logistics and unforeseen miscellaneous.
- To Pay Off Debts-: If an existing business has strong cash flow, the entrepreneur can capitalize on this to borrow long term loans which will be used to pay off short term debts. This can only be achieved if the business has strong cash flow and potential to grow or expand.
- For Expansion-: This is a major reason entrepreneurs borrow funds for their business. If an entrepreneur perceives an opportunity outside the industry of his business, and the feasibility shows there is a chance for success, the entrepreneur can borrow funds to diversify or expand his existing business. An entrepreneur may also borrow funds for acquisitions if the existing market of his business is saturated.
Advantages and Disadvantages of Taking Small Business Loans
Although having to pay an interest alongside your principal may be somewhat burdensome, taking a business loan has its advantages, as well as disadvantages.
So it is up to you to consider this pros and cons carefully, weigh the options involved and then decide if taking a business loan will be good for your business. Without wasting your time, below are the advantages and disadvantages of taking small business loans:
5 Advantages of Taking Small Business Loans
- Convenience and accessibility-: Banks are always and readily accessible since they are used regularly for saving and withdrawing money. After using a particular bank for years, the bank becomes convenient and familiar to you, and so it comes to your mind first when you are thinking of taking a bank loan.
Similarly, government agencies that issue loans usually have several offices, thus making it easy for entrepreneurs to approach them. And because of the general knowledge that these agencies have been established specifically for issuing loans to small businesses, they are usually one of the first places to consider for a loan.
- Multiple options and packages-: All loan-issuing institutions have multiple types of loan schemes for entrepreneurs trying to set up or expand their businesses. These packages vary in terms of principal, interest rates, and repayment period so that entrepreneurs can choose the most convenient ones for them and the most suitable ones for their businesses. Also, having the option to take line of credit loans can help entrepreneurs spend their loans more carefully.
III. No profit or control sharing-: Venture capitalists and angel investors will give you the funds needed to start or expand your business, but they will in return take part of the ownership of your business. This means any profit that comes in will be shared between you and them, and they have the right to influence decision-making. However, banks and other loan-issuing institutions don’t ask for part ownership of your business. If they give you a loan, they are only interested in getting their interest and partial loan payment installments.
- Tax benefits-: Small businesses taking loans from banks and some other institutions enjoy some tax relief, since the percentage of profits used to repay the loan is exempt from tax. So, you only have to pay tax on the percentage of profits that you will keep for yourself.
- You don’t have much to lose- : Another benefit of getting a business loan is that, if your business fails, you may not necessarily have to pay back from your personal purse. In the event of failure, you can liquidate the business, which will help you pay back part—or even all—of the borrowed funds.
In fact, many business owners keep this advantageous aspect in mind when borrowing money, because they will only lose their business in the event loan default, not necessarily their own money or the collateral used to secure the loan. And many creditors accept this repayment plan—of course, they don’t care about whatever you will lose to pay back the loan; all they want to ensure is that you pay back the loan after all.
5 Disadvantages of Taking Small Business Loans
Though some loans may attract very little interest rates and may be repayable over long periods of time, taking loans to finance your business has its fair share of disadvantages. And it is very important that you weigh these against the advantages to figure out whether taking a loan would be a right step for you. Here are the disadvantages of taking business loans:
- Lengthy application process-: Banks and other loan-issuing agencies need to verify all the credentials and details about your business before approving a loan. Most importantly, they need to ascertain that you are really capable of paying back the loan along with the accompanying interest. All these explain why the loan application process and review always take a long time.
- Cumbersome process-: Banks and other institutional creditors have a long list of conditions that your business must fulfill before they can take a loan. Trying to meet these conditions (for example, trying to provide certain business details and documents) is always cumbersome. In fact, most of these conditions, from the entrepreneur’s perspective, are totally unnecessary. And sometimes, it is not possible to meet all of them. This is one of the commonest reasons why entrepreneurs don’t bother giving loan applications a shot.
- Preference given to existing businesses-: Most banks and some other credit institutions prefer issuing loans to existing businesses rather than startups, because they can easily gauge an existing business’s profitability and credit history before approving a loan. And because new businesses don’t have such records, there is a common fear among creditors that the loans may not be repaid.
- Risk of losing collateral-: You cannot secure a business loan without some collateral, which is usually your house or other valuable property. Should you fail to pay back the loan within the specified term, you risk losing the collateral. Although, you have the option of liquidating your business, you may still lose your collateral if your liquidations cannot pay the loan completely.
- Getting entire amount not guaranteed-: Some banks and other credit institutions fail to grant the whole amount requested for a loan. They may grant only 70-80% of the money you applied for—or even less. This will make it difficult for you to implement your business plans right away, since you will still need to approach other sources to get the remaining balance before you can start.
Overall, there is some kind of balance between the advantages and disadvantages of taking business loans. And it is this balance that prompts most entrepreneurs to approach banks and other agencies for loans.
How to Know How Much Money or Loan to Apply For
You see, different types of business need different amounts of capital in order to be established and there are several small business financing options available. Some entrepreneurs dare to get start up business loans that is worth of millions of dollars just to start their own enterprise. Of course, getting business loans can be risky, both for the lending firm and the one who acquires the business loans.
Amidst the world economic turmoil which has started from the collapse of big businesses at Wall Street, establishing a business is actually taking a huge risk. It is not only that some banks and other non-bank lending institutions are tight in giving up money as start up business loans; your financial and credit status also play a very crucial part in getting business loans.
Since start up business loans are part of the firm’s business, the primary goal in giving loans to perspective clients is of course, to ensure profits. These profits are in the form of interests. Some banks and other lending institutions refuse to give up much money, especially if they know that the debtor cannot pay that much, or will have a difficulty in paying the loaned amount due to the current economic situation of the world.
However, there are some financial institutions that are willing to take risks by giving start up business loans that amount up to 70 percent of the total assets of the person acquiring the loan. But the question is not actually the risk of non-approval of your start up business loans application but how much money does your business need to be able to have it jumpstarted? Well, the tips below will help you.
- Study your business first and the opportunities therein-: A careful study of the business opportunities and the skills at hand could be the first step in determining how much money to get from start up business loans. To put up an internet café, for example, you won’t need millions of dollars. But when venturing into real estate development, you will require you bigger amount that business loans could be up to billions of dollars since acquiring lands, equipment and the other needs for the said business are not that cheap.
- Consider your capability to pay back the loan-: Small and micro-business, like a small internet café or a small coffee bar, can easily get start up business loans for the capitalization would not exceed up to US$ 5 million. But the smallness or the bigness of the amount of the business loans are also dependent on your own capability of paying the start up business loans incurred.
- Check your credit history / financial statement-: Actually, financial institutions, banks and other SBA firms, look into your financial history to determine whether you are qualified to be given start up business loan or not. They will check how much money you have in your account, the cost or value of your home, and other assets that can easily be turned into cash just in case the bad weather comes after your business, disabling you to pay your outstanding loans—the interests, plus the penalties due to nonpayment of the loans incurred.
In reality, capital is not the issue in making the business profitable; it is your financial management skills, plus making those intelligent decisions would make your business successful. Some hotdog vendors have had their fortune just selling hotdogs. Take note: they just spent a few and now they are garnering more. Think about that.
3 Kick-Ass Tips for Obtaining Start up Business Loans Fast
How do you increase your chances of obtaining a start up business loans? What are the best strategies or tips for applying for a start up loan? Well, i suggest you read on to find out.
Always bear in mind that start up business loans are similar with personal loans. Banks and other financial institutions do not want to lose money and asking them to give you start up business loans could be tough. However, if you would have given a chance to have that start up business loans that you are dreaming of, then that’s very lucky of you.
When obtaining start up business loans, it is better to get a professional financial advisor to guide you in getting that start up business loans. That financial advisor will explain to you all the things that you need to know about start up business loans, how to get one and what the repercussions are in obtaining specific start up business loans.
Your financial advisor would help you to gather the necessary facts about the business, prepare the papers if necessary, and even back you up to get those start up business loans in order for you to start your business. Your financial advisor will also teach you how to maximize your money-making potentials in order to pay your loans in due time and even to obtain more loans for your business expansion.
Nevertheless, your financial or credit history will also predetermine the ease or difficulty of obtaining any kinds of loans. That is why, it is very important to pay your early loans, both the principal and interests in due time to avoid penalties and not to have a bad record from any financial institutions.
On the other hand, being a homeowner can give an edge to obtain a business loan. You can use your own house and lot to serve as your collateral for your business loan. For banks and non-bank lenders, as it was mentioned before, are conscious about their return of investment. So if you want to obtain that loan easily? Here are some tips that will help you:
- List down all your assets and liabilities-: It is important to check the things with value at hand as these things would serve as collateral or payment in case you default on the loan terms. Just keep your fingers crossed for the worst thing not to happen, this is in case you cannot pay the loan or credit anymore. Cars, jewelries, and equipments that can be turned easily into cash can be enlisted as part of your assets. Your outstanding loans and credits would go to the liabilities’ list.
- Ensure that you had a good income record throughout the year-: Since start up business loans are considered as part of the “high-risk brackets” in terms of financial loans, banks and non-bank lending institutions are very cautious in lending money to new business persons. If you can show the management of the lending institution that you can pay, then there’s a little chance that your business loan would be denied.
Lastly, It is important to give them the exact blueprint or financial plan of your business so that they would know where you will be using the money that you are loaning. It is good to give them the breakdown of the proposed allocation or distribution of the loaned funds in order to give the bank management enough reason why they should take heed to your request.
7 Facts You Must Know When Borrowing Money for your Business
“Capital can do nothing without brains to direct it” – J. Ogden Armour.
The primary duty of every entrepreneur is to continuously raise capital for his business. Many entrepreneurs borrow money or take a loan blindly and in the end, they bite their fingers in regret. This section will explain to you basic facts you need to know when taking a loan. In the process of borrowing money, or better still, taking a loan:
- You must know the terms of Repayment-: Some times, when small business owners borrow money, they have no choice in choosing the repayment term. When taking a loan, you have to be sure of the terms of repayment. An example of a good question you should ask is: Am i going to repay on installment or not? When you know the terms of repayment, you can strategize on how to utilize the loan you are taking.
- You must know the Interest rate-: This is a simple but yet the most confusing subject for entrepreneurs. When borrowing money for your business, you must demand to know the interest rate or better still, get an accountant to trash the issue of compounding out. Many entrepreneurs ignorantly fall into the compound interest trap without knowing it and in the end; their entire profit is used in repaying the loan. So my best advice is, get an accountant. PERIOD.
- You must know the loan maturity date-: Knowing the loan maturity date will help you plan how the funds will be spent. If it is a long term loan, you can use it to solve long term business needs and vice versa. The major mistake most entrepreneurs make is using short term loans to solve long term needs. This act makes them fall into the credit crunch. Be wise, know your maturity date and plan appropriately.
- You must know the cost of taking the loan-: When borrowing money for your business, you must know the cost of taking the loan. Some financial institutions require you leave a fixed deposit with term, some might charge transaction and legal fees. By knowing the cost of the loan taken, you can tighten up your financial statement.
E. You must present endorsers-: This is a simple rule in the game of borrowing money. You must present an endorser or show your credit history. This is just to show you are credit worthy.
- You must know the true value of the collateral you are to provide-: This is a very important rule you must not joke with when taking a bank loan. To me, it is mere stupidity to put down a one million dollar commercial building for a loan of $300,000. So before putting down a collateral, make sure you appraise it and know its actual value.
- You must have total control over the direction and utilization of the funds-: This is a vital factor that can never be over emphasized. Control is the most important word in the world of business and investing. Some banks lend money to entrepreneurs and still try to control the affairs of the entrepreneur’s business. Some lend money to investors and still dictate to the investors the type of company stock they should buy. So be careful, control should be your watch word. It is your birth right, don’t sell it