The main advantages of loans are that terms can be tailored to suit the needs of the business. Similarly, repayments are straightforward, simply planned and the cash flow impact can be budgeted for. Finally there is tax relief on the interest payments, unlike dividends.
However, banks can be reluctant to lend money to new business owners with no financial track record and loans themselves are less flexible than overdrafts. Charges could be payable on funds that are not used and regardless of usage, you will be locked into a rigid repayment schedule.
If pursuing a bank loan, it is worth understanding the criteria banks use when judging a potential business loan:
Character: Do we want to lend to this person? We assess the person as much as any deal they want to borrow against, to examine whether the individual is trustworthy and whether they have a relevant track record.
Capability: Is this person skilled in the detail and knowledge of their business, and financially capable? Are there sufficient skills in the whole management team to run the business?
Capital: What assets do the applicants have? How much is committed to the project? The loan amount requested should be in proportion to the customer’s own stake, with banks rarely lending more than 70% of the total cost of the project.
Purpose: The bank needs to establish that the purpose of the loan is fit and proper and in the customer’s best interests.
Amount: Is the applicant asking for the right amount to fund the project? Is it consistent with what they are doing in the business overall? Applicants can be optimistic and overlook potential problems; the lender can bring realism to the project.
Repayment: Can applicants provide evidence of their ability to repay? This can be done through thoroughly tested revenue projections, or if the business relies on a small number of significant orders, through a legal commitment from the buyer to pay.
Terms: The terms set the cost of the loan: the interest rate and other fees. This is determined by an assessment of the risk versus rewards. Proposals that have adequate security attract a lower interest rate than unsecured deals. The amount and complexity of work involved to assess the loan determines the level of fees.
Security: There needs to be a ‘second way out’ for the bank, something that it can reclaim or repossess if the loan holder defaults on their loan.