Small businesses take out commercial bank loans with the hope of using borrowed capital to become more profitable. Loans can come from sources other than banks, such as credit unions, public funds, or private investors, and small businesses can use inventory or accounts receivable as collateral.
Depending on where and how the loan originates, borrowing money can be dangerously expensive, as interest and fees are associated with virtually every loan. Businesses can and should calculate the amount of total interest that will be paid over the course of a loan before accepting one.
Below are four reasons taking out a business loan can be worth the risk.
1. To Purchase Real Estate and Expand Operations
Banks are likely to loan money to existing firms that want to purchase real estate to expand their operations. Expansion generally happens if a firm is turning a profit, has a rising cash flow, and has positive forecasting numbers for the future. This is a scenario that makes a bank likely to approve a small business loan. Bank loans for real estate are usually in the form of a mortgage. Long-term bank loans will use company assets as collateral, and will require monthly or quarterly payments from profits or cash flow. The loan term can run anywhere from 3-25 years and will have an interest rate associated with its repayment.
2. To Purchase Equipment
Businesses have two choices with regard to the acquisition of equipment: they can buy it, or they can lease it. If a business owner borrows money to buy equipment, they can take a tax write-off of $25,000 the first year, and depreciate the rest of the equipment over its economic life. The equipment can also be sold for salvage value when it’s outdated or no longer functional. A cost-benefit analysis is necessary to determine whether it’s better to buy or lease equipment for a given company. When a bank makes a loan for equipment, it’s usually an intermediate term loan which runs less than three years and is repaid in monthly installments. Repayment will often be tied directly to the useful life of the equipment being financed.
3. To Purchase Inventory
Banks sometimes make short-term loans (repaid within a year) to small businesses that have developed a trustworthy relationship with the bank. Making payments on time and holding a positive balance in a checking or savings account are both ways to build trust with a bank. Some small businesses are seasonal in nature, such as retail, hospitality, and agricultural businesses. If a company makes most of its sales during the holiday season, they can take out a short-term loan to purchase most of their inventory in advance. Bank loans to purchase inventory are generally short-term in nature; companies strategize around repaying them once the season is over, using proceeds from their seasonal revenue.
Working capital is the money used to manage day-to-day business operations. Small businesses may take out a loan to satisfy operational costs until their earnings reach a certain volume. If the debtor has good credit and a solid business plan, a bank loan can offer short-term money for a business to get off the ground and grow. Working capital loans generally have a higher interest rate than real estate loans because banks consider them riskier; if the business is mismanaged at a crucial time during its infancy, or if the earning assets of the business never generate a profit, the company will face bankruptcy.