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Entrepreneurs and small business owners looking for capital to grow their business can seek equity capital from investors or borrow from lenders. Seeking new capital is time-consuming, subject to federal and state laws and requires distribution of future profits. In some cases, the owner may even lose control of his company if management decisions must be approved by an outside board of directors.
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On the other hand, warnings about borrowing have been spread by small businesses for centuries. Stories of aggressive debt collectors, careless bankers, and unscrupulous borrowers are passed down from generation to generation as evidence of the seemingly inevitable consequences of taking on business debt. Like other myths and legends, the negative aspects of small business loans are often exaggerated.
Small Business Lending Statistics For 2021 (+ Financing Options)
Here’s why a small business loan may be right for you, and an overview of your options.
The smart use of credit by small business owners is a financial strategy that should be embraced, not scorned. Advantages of smart debt financing include:
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While there are many advantages to incorporating debt into the capital structure of a business, the important point is that the debt must be repaid at some point if the business is to continue. Borrowers should know that:
Things To Know Before Securing A Small Business Loan
Business loans are available in many forms, each with its own purpose and features. Below are some of the more common ones.
Uncollectible accounts hoard cash and reduce cash flow. If a company does not operate on a cash basis, there will always be an accounts receivable balance at the end of the month. For example, if you provide payment terms 10 days after the invoice date, sales that occur at the end of one month will not be collected until the following month.
Small companies that sell competing products to large customers often have difficulty enforcing credit terms. One of my investments, a lumber company in Mississippi, sold utilities and railroads all over the country, most of which were paid within 45-60 days of invoices. Although these customers were not credit risks, their slow payments hurt our cash flow. Resolved the issue of revolving accounts receivable.
Banks like to lend to checking accounts because they have quick cash to pay off the loan. For these loans, banks generally agree to advance 70% to 80% of the receivable balance on accounts less than 60 days old. Some banks may offer a different percentage of the amount based on the age of the accounts, such as 90% of the balance for accounts 30 days or less, 75% of the balance for accounts 30 to 60 days old, and 50% of the balance. Account balances between 60 and 90 years. Few banks will accept accounts receivable older than 90 days as collateral, so these accounts have no collateral value.
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In a typical AR loan, the company submits a schedule of receivables to the bank and receives cash at calculated values. As the month progresses, old accounts are collected while sales generate new accounts. A new loan balance is calculated at the end of each month.
If the following month’s balance exceeds the previous month’s balance, the bank provides the company with an additional amount equal to the difference minus interest. If the following month’s balance is less than the previous month’s balance, the company returns the difference to the bank, plus interest. As a result, the loan balance changes every month. In both cases, the old debt is paid off and a new loan is issued.
Some banks consider accounts receivable collection by requiring invoice payments to be made only to a bank account set up for that purpose, thus ensuring that the bank is aware of all payments received by the company. In some cases, the bank allows the company to continue the collection process, relying on the company to submit timely collection reports to the bank and have sufficient cash on hand when loan payments are required.
In addition to secured receivables, the bank may require personal guarantees from the company’s owners as additional collateral.
Might It Be Time To Consider A Small Business Loan?
Some entrepreneurs prefer to “pool” accounts receivable rather than borrow against their value. Factoring is the sale of receivables by a third party (the factor) at a discounted face value. Companies like Bluevine allow you to turn unpaid invoices into working capital. You can be approved in just 24 hours with rates as low as 0.25% per week.
Depending on the negotiations between the factor and the company, the factor may assume all or part of the group and project risk. In the latter case, the factor may reserve the right to charge back the uncollectible accounts to the company for amounts previously paid on credit. Small business owners should be aware that the tax treatment is different for AR loans and factoring arrangements.
Storage of raw materials and finished products or inventories is important for many companies. Without raw materials, a manufacturer cannot create products to sell, and a retailer without finished goods cannot satisfy customer needs.
Our lumber operations have invested thousands of dollars in pre-cut lumber and greenwood railroad ties, which have been used primarily to replace railroad tracks, fences, and tracks destroyed by storms. Customer demand for these products will be high after each hurricane, and our ability to ship products quickly was critical. If we didn’t have the right size rod on hand, our customers would turn to our competitors. As a result, our inventory value exceeded the facility’s book value.
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Like uncollectible accounts receivable, inventory represents an inactive asset that earns nothing and uses cash until it is sold. There were always green logs waiting to be processed and finished rods and ties waiting to be sold. In order to increase cash flow, we initiated a series of short-term loans in succession using inventory as collateral.
Unlike accounts receivable, banks and financial institutions are reluctant to use assets as collateral, especially if they require additional investment before they can be sold as a finished product. As a result, banks rarely lend more than 50% to 60% of the value of finished goods, with lower percentages of work-in-progress and raw materials, if either accepted as collateral.
Asset loans work the same way as accounts receivable, the loan balance fluctuates with changes in collateral inventory. If the value of the collateral exceeds the previous month’s balance, the loan balance is increased and the additional amount is prepaid. When the value of the collateral falls below the previous month’s balance, the company must repay the difference by reducing the loan amount.
For example, our bank agreed to provide a loan to the company for 50% of the company’s finished products and 40% of the value of raw wood. During the first month, we had $250,000 in finished products and $140,000 in raw lumber, allowing us to borrow $181,000 (50% of $250,000 and $40% of $140,000). The next month we worked, sold our products, turned green wood into medicine, continued to buy raw materials. At the end of the month, we had $175,000 in finished inventory and $185,000 in raw lumber, which matched the new credit of $161,500 (50% of $175,000 and $40% of $185,000). We paid off the old loan of $181,000 and signed a new loan of $161,500 for a total of $19,500, also paid one month’s interest.
How To Qualify For A Small Business Loan
The inventory values listed in the company’s accounting records must be regularly checked and verified with regular inventory counts, with the lender making adjustments to the loan as necessary. Depending on the terms of the loan, the bank may require the company to maintain physical accounts more often than usual, adding additional administrative costs.
As with AR loans, business owners are usually required to verify the value of the property receiving the bank loan. If you currently have a successful business, OnDeck is a great online lender for startup loans. However, if you are a new business or have a low credit score, Kabbage may be a good option.
Equipment loans are usually secured by tangible assets that are purchased along with the loan. Mortgage terms typically range from three to eight years and are amortized over the life of the loan.
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