If you’re a small business owner, you already know that it takes money to make money. The only problem is…what do you do if you don’t have any money to start with?!
Banks can help you get going in the form of a loan. You’ve got the idea and the passion to make it happen, and they’ve got the money you need.
If you’re wondering, “how do small business loans work?”, keep reading to learn more.
Raising Capital for Business
The money that is necessary to run your business is known as “capital.” Investopedia defines capital as the money in a company that is “available to pay for its day-to-day operations and fund its future growth.”
As Investopedia further points out, capital can broadly refer to any of the equipment, machinery, physical property, or intellectual property that makes it possible to produce a product or service. While that is technically correct, for the purposes of discussing small business loans in this post, we’ll stick to thinking about capital as money.
Money (especially cash flow) is the lifeblood of your business. That kind of capital is what allows you to purchase everything else that your business needs.
Whether your capital comes from your own pockets or someone else’s, it’s a good idea to partner with a good CPA (who does more than just taxes) before you come into large amounts of money so you maximize every dollar of it to grow your business. When you’re ready, we’re here for you! Schedule a call with our business pros who can guide you through it all.
Most businesses aren’t able to fund their own success. Most of the time, they need a financial boost in order to get started. That kind of capital often comes from small business loans. Next, we’ll take a look at how small business loans work, the types of business loans, and what you need to do in order to get one.
How Do Small Business Loans Work?
At the most basic level, a small business loan is like any other loan:
The person in need of money asks to borrow some from someone who has it.
The lender loans them the money.
The borrower agrees to pay the money back, plus some extra (interest), over a specific period of time.
The world of business loans can quickly become much more complicated than that, however. That’s why it’s wise to partner early on with a good financial guide to help you navigate all of your options.
Let’s take a look at a few of the various types of business loans and see how they work. Some are fairly straightforward, like our example above, while others are much more involved.
Types of Business Loans
Term
A “term loan” is what we described in the section above. Person A borrows money from Person B. Person A then makes regular payments (plus interest) over an agreed-upon period of time until the loan is fully repaid. Term loans usually involve larger amounts of money than other types, longer repayment periods, and lower interest rates. If you can get someone to agree to one of these, it can be one of your best bets.
Short-Term
These work a lot like a regular term loan. The difference, however, is that they involve smaller amounts of money over shorter periods of time (hence the name) at higher interest rates. Individuals who need money quickly and anticipate being able to repay it quickly in order to get out of debt as quickly as possible benefit most from this kind of loan.
Self-Secured
Many times, money is needed in advance to purchase an expensive piece of equipment or fund a particular project. In these cases, the money borrowed to pay for those things can be considered a “self-secured” loan…meaning that the thing itself becomes the collateral (proof to the lender that you will either be able to repay or give them the item). Two examples of this type of loan are:
Equipment Financing
You can borrow 100% of the cost of the equipment because the lender can simply take possession of the equipment if you fail to pay. Because of that option, lenders typically offer equipment financing at much lower rates.
Invoice Financing
In this scenario, you borrow against outstanding invoices your business has. The promise of money coming in (provable by invoices for work you have already done) serves as collateral. However, you will likely only be able to borrow up to a certain percentage (perhaps 75% to 90%) of the value of the invoice. The remaining amount is held in reserve until the customer pays in full. Once that happens, it will be passed on to you (minus some fees).
SBA
SBA loans are issued by banks, but are partially guaranteed by the Small Business Administration. As a result, banks are much more willing to approve these kinds of loans because they have more assurance that they’ll get their money back…at least the part covered by the SBA.
These loans are longer-term, lower interest rate products involving fairly high dollar amounts. However, the SBA offers 3 different types of loans to cover a wide range of needs. You can learn more about SBA Loans here.
Business Loan Requirements
Whenever you apply for a business loan of any kind, lenders are going to want to look at a few basic things regarding your company’s finances:
1. Credit Score
Banks and other creditors will check both your business credit score and your personal credit score. Business scores are measured between 0 and 100 using the PAYDEX Score by Dun & Bradstreet. Personal scores are done through FICO and range from 300 to 850.
A poor personal credit score may not automatically end up in your application being rejected, but a good personal score definitely boosts the lender’s level of confidence.
2. Financial Statements
Lenders want to know if your company makes enough annually (or monthly…depending on the loan) to be able to realistically pay the money back. Usually, bank statements and income tax returns are sufficient, but some people may want to see a profit and loss statement as well to evaluate how cash flows through your business.
3. Time
Borrowers who have been in business longer stand a better chance of getting their loan applications approved. Requirements vary based on the lender and the kind of loan you are seeking.
4. Income-to-Debt
The term for how much income you have coming in versus how much you owe is your “debt-service coverage ratio” (DSCR). It is determined by dividing your “earnings before interest, taxes, deductions, and amortization” (EBITDA) by your total annual debt.
A DSCR greater than 1 indicates to lenders that you have more money coming in than what is already committed to going out. Therefore, you will probably have enough to repay whatever loan you are currently applying for.
5. Collateral
Secured loans will require that you offer something of value that the lender can take possession of in the event that you are unable to repay. For some loans, such as Equipment Loans or Invoice Financing like we mentioned above, the thing you’re getting or the money someone else owes you is the collateral. For others, it could be property, other equipment, or even personal assets.
6. Industry
Some types of businesses naturally carry more risk than others simply by the nature of what they do. If your line of work is traditionally more volatile financially, lenders may shy away from doing business with you. Before you begin any business loan process, make sure the lender is willing to even consider working with someone in your industry first.
For Success in Business Loans, Partner With Someone Who Knows The Way
At CRS CPA, we’ve seen thousands of companies successfully get the financing they need over our 40+ years in business. We understand how important capital is to being able to grow your business, and we’d love to partner with you. Our small business experts work with all kinds of Professional & Service Businesses and we can make sure you’ve got all your paperwork in order when you approach lenders.
