Businesses often need to borrow money to finance business investment activities. Here are some of the types of loans a business might take out.
A commercial loan is a debt-based funding arrangement that a business can set up with a financial institution. The proceeds of commercial loans may be used to fund large capital expenditures and/or operations that a business may otherwise be unable to afford. This type of loan is usually short-term in nature and is almost always backed with some sort of collateral. Commercial loans usually charge flexible rates of interest that are tied to the bank prime rate or else to the London Interbank Offered Rate (LIBOR). Many borrowers must file regular financial statements, usually at least annually. Lenders also usually require proper maintenance of the loan collateral property.
Due to expensive upfront costs and regulation-related hurdles, smaller businesses do not typically have direct access to the debt and equity markets for financing purposes. Therefore, they must rely on financial institutions to meet their financing needs.
A term loan is a loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate. Term loans almost always mature between one and 10 years. Businesses use term loans for month-to-month operations or to purchase fixed assets such as production equipment.
An unsecured loan is issued and supported only by the borrower's creditworthiness, rather than by some sort of collateral. Generally, a borrower must have a high credit rating to receive an unsecured loan. Commercial paper is an example of an unsecured loan. A secured loan is backed by collateral; if it is not repaid, the lender can seize the collateral and sell it to recover the funds it lent.
An acquisition loan helps a company purchase a specific asset that is determined before the loan is granted. Acquisition loans are sought when a company wants to complete an acquisition for an asset but does not have enough liquid capital to do so. The company may be able to get more favorable terms on an acquisition loan because the assets being purchased have a tangible value, as opposed to capital being used to fund daily operations or release a new product line. The acquisition loan is typically only available to be used for a short window of time and only for specific purposes. Once repaid, funds available through an acquisition loan cannot be re-borrowed as with a revolving line of credit at a bank.
Revolving credit is another way businesses can borrow money, but the structure is a bit different than an ordinary loan.
A line of credit establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement.
The advantage of a line of credit over a regular loan is that interest is usually charged only on the part of the line of credit that is used, and the borrower can draw on the line of credit at any time. Depending on the agreement with the financial institution, the line of credit may be classified as a demand loan, which means that any outstanding balance will have to be paid immediately at the financial institution's request.
Revolving credit may also be called an evergreen loan or a standing loan. Credit cards are also a type of revolving credit.
More Complex Loans
A self-liquidating loan is a type of short or intermediate-term credit that is repaid with money generated by the assets purchased. The repayment schedule and maturity of a self-liquidating loan are designed to coincide with the timing of the assets' income generation. These loans are intended to finance purchases that will quickly and reliably generate cash.
A business might use a self-liquidating loan to purchase extra inventory in anticipation of the holiday shopping season. The revenue generated from selling that inventory would be used to repay the loan.
Self-liquidating loans are not always a good credit choice. For example, they do not make sense for fixed assets, such as real estate, or depreciable assets, such as machinery.
Another type of loan related to a business's assets is an asset-conversion loan, a short-term loan that is typically repaid by converting an asset, usually inventory or receivables, into cash.
For example, let's say the TSJ Sports Conglomerate is short on cash it needs to pay its employees this month. One option they might explore is trying to get an asset-conversion loan to fill that short-term cash void.
Another type of loan that can help a business meet its day to day needs is a cash flow loan. Reasons for needing a cash flow loan could be seasonal-demand changes, business expansion or changes in the business cycle. Cash-flow loans can help in temporary situations, but if cash flow problems persist then companies need to improve their cash conversion cycle and get customers to pay faster.
A working capital loan can also be used to finance everyday operations of a company. It is not used to buy long-term assets or investments, but rather to clear up accounts payable, pay wages and salaries, and so on.
A company can also pledge its accounts receivable (AR) as collateral for a loan. A non-notification loan is a type of full-recourse loan that is securitized by accounts receivable. Customers making accounts-receivable payments are not notified that their account/payment is being used as collateral for a loan. They continue making payments to the company that rendered services or made the original loan, and the company then uses those payments to repay their lender for financing obtained. If customers do not pay accounts receivable, the company is still liable for repaying the loan it obtained using the AR as security.
A bridge loan, also known as "interim financing," "gap financing" or a "swing loan," is a short-term loan that is used until a company secures permanent financing or removes an existing obligation. This type of financing allows the user to meet current obligations by providing immediate cash flow. The loans are short term (up to one year) with relatively high interest rates and are backed by some form of collateral such as real estate or inventory.
As the term implies, these loans "bridge the gap" between times when financing is needed. They can be customized for many different situations. For example, let's say that a company is doing a round of equity financing that is expecting to close in six months. A bridge loan could be used to secure working capital until the round of funding goes through.
This is not an exhaustive list of the types of loans available to businesses, but it gives a general idea of the different options available. Businesses should shop around at different institutions to determine which lender offers the best terms for the loan.
Alternatives To Loans
Personal FinanceA loan is the act of giving money, property or other material goods to another party with the expectation of being repaid.
Personal FinanceHow to tell whether a personal loan or a car loan is better for you.
InvestingA loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate.
InvestingFind out what options are available when it comes to borrowing money.
MarketsGovernment loans further policymakers' efforts to create positive social outcomes by offering timely access to capital for qualified candidates.
Personal FinanceLearn about different avenues for applying for a personal loan, and learn valuable tips to help you get your personal loan application approved.
MarketsUnderstand the differences between a small business loan and a line of credit, and learn some of the most appropriate uses for each form of financing.
Managing WealthYou never want to borrow money for frivolous reasons, but these five circumstances might warrant it.
Managing WealthObtaining a commercial real estate loan is quite different from borrowing for residential real estate. Here's what to expect and how to get what you need.
RetirementThinking of adding a loan feature to your company's plan? Here's what you need to know.