Denice R. Preston
A business loan can help you get the capital you need to sustain and grow your business. Three things are changing the business lending landscape: the increased use of technology, easy access to credit histories, and the ability to use “alternate data” to assess creditworthiness.
Lenders, whether they are banks, finance companies, or others, expect prospective borrowers to answer convincing questions about three key aspects of a loan for business:
- The need that the loan is needed.
- The amount borrowed.
- The collateral or security the borrower is willing to offer.
Let’s look at how these three elements work together to help you get a loan for your business:
1. Specific Needs for which you require a business loan
Depending on your needs, there are many options available to you from banks and financial institutions for business loans. You may require a business loan to:
- Your business will grow
- To fulfill a large order
- Diversification is a way to turn a downturn in a business into a profit.
Consider your needs and determine which type of loan is best for you. Different types of loans can be classified based on their repayment structure. These are:
2. Business Loan, Term Loan
- This is a loan that must be repaid within a set period. This could be for 24 months and a predetermined pattern of installments.
- You can choose to pay monthly or quarterly installments. The pattern could also be called “equated monthly Instalment” (EMI) or principal repayment. This means that the principal and interest are equal.
- There are many options for the predefined repayment arrangement. The most popular ones are the equated monthly installments and equated principal repayments.
A term loan’s structure is easy to understand. The business will know the repayment obligations and the frequency of repayment. They can also plan their cash flow to make regular payments.
However, every business is subject to fluctuations in cash flow. The term loan doesn’t allow the business to adjust its borrowing levels to seasonal cash flows. Therefore, you should plan to obtain the maximum amount of borrowing that you can use during the business cycle.
Business Overdrafts
- These borrowing facilities allow the lender (mostly the bank) to set a maximum borrowing limit. The business can then withdraw funds within that limit at any time.
- The repayment schedule is flexible, as there are no installments or fixed repayment patterns. However, the bank expects the business to pay the interest monthly or quarterly.
- Business credit cards can also be considered a type of overdraft. These facilities are reviewed annually by the bank and must be renewed.
- Banks offer this facility to customers with good credit scores. Also known as “good credit risk”,
This arrangement has the advantage of adjusting its borrowing levels to suit its seasonal cash flows.
A bank can take back the loan at the annual review. If the bank is unhappy with the repayment frequency or concerned about the operation of the borrower’s company, this can occur.
Trade Finance
- This type of loan is tied to the completion of a business transaction. A “receivable discounts” facility, for example, will be repaid once the supply chain partner has received the receivable. The bank will usually set up a rotating financial limit within the scope of which all receivable instruments can be funded and must either be repaid or retired.
- These loans are for a short time and can be obtained from a lender.
- They can come in many forms. These include invoice discounting, receivables discounting and merchant cash advance.
This facility has the advantage that it can be integrated into daily business transactions, so there are little to no unused funds.
A business cannot borrow unless there is an underlying supply chain transaction. There is no need to lend if there isn’t a transaction. This cannot be used to manage rotating working capital.
What Borrowing Limit or Amount You Need?
The financial institutions conduct their research to determine how much borrowing is necessary. To arrive at a reasonable amount, they use the business’s working capital ratios and leverage rates.
Businesses must compute the amount they are seeking after carefully analyzing the cash flow of their business. The amount requested should not exceed the business’s cash flow (or the business may have difficulty managing liquidity). It should also not exceed the bank’s internal policies.
Based on these factors, the lender will evaluate your application for a business loan and determine the creditworthiness of your business.
Willingness To Repay
For a lending institution to evaluate your creditworthiness, the first step is to examine your company’s track record in repaying loans in a timely fashion.
Lenders will review your credit scores at credit bureaus and your company credit report (CRR) to determine the repayment history of your company. Only if credit scores exceed the prescribed limit can they approve the application.
A secured loan requires the borrower to submit collateral. Credit scores of more than 600 are acceptable.
An unsecured loan does not require the borrower or collateral to be present. A credit score of 700 is recommended.
Good credit or CCR can open up more options for borrowing money, but it can also influence the interest rate at which the loan is extended.
The credit history of new business borrowers is expected to improve over time. They will start with a small loan facility and then move on to larger loans based upon their repayment record.
Payability
After establishing that credit scores are within acceptable limits, the lender will assess the borrower’s repayment ability.
To assess the lender’s willingness to accept a certain amount of risk, the lender will examine the cash flows, profitability and stability of the borrower, and the ability to pay the EMI obligation.
A strong balance sheet will increase your chances of getting a loan for your business.
The borrower can offer collateral or security.
For new business loans, most lending institutions will require collateral. A collateral could be an asset of the business (such as machinery) or the owner’s personal property. This is a crucial requirement for secured loans, but an unsecured loan can also be available at a higher interest rate.
Many businesses are not organized and may not meet collateral requirements. Banks and other formal lending channels will reject these businesses. These businesses may seek alternative lenders that provide loans for businesses without collateral.
Alternate lenders use digital data, including data from banking and social media, to assess the business’s creditworthiness. They use machine-learning algorithms and psychometric evaluation to determine whether a loan is granted to a small or medium-sized enterprise.
Referencing and document verification
Referencing and document verification are the final steps in the evaluation process. The lender will conduct reference checks with two of the borrower’s supply chain partners and verify the authenticity of all documents submitted for evaluation. An instant rejection can be caused by a negative verification or reference check.
A bank might offer business facilities specific to a particular industry or segment of borrowers. Examples include loans for women entrepreneurs or textile machinery loans. Lenders will give preference to applicants who meet these requirements.
