The sustainability and management of a company or organization requires the availability of capital – a need that can be met by seeking a business loan. Besides the traditional methods of obtaining a loan, there are three aspects that are revolutionizing the field of business lending: increased adoption of technology in financing, ready availability of an individual’s credit history and the use of “surrogate data” to assess creditworthiness.
The lender—whether it is a bank, finance company, or any other company—expects a potential borrower to have persuasive answers to three main aspects of a business loan: the specific need for which the loan is needed, the amount of borrowing, and the collateral or security that the borrower can provide.
Let’s dive into how these three aspects can help you get a business loan.
1. Specific need that requires a business loan
Banks and financial institutions offer a variety of business loan options to choose from depending on your specific needs. For example, you may need a business loan to:
- Growth in your business
- To meet a large demand
- To turn a business downturn opportunity into profit through diversification
Depending on your need, think about the type of loan that is right for you. The types of loans can be classified into different categories based on the repayment structure. These include:
a) Business loan or term loan
- This is a loan that must be repaid in a specified period of time. For example, for a period of 24 months with a predetermined installment pattern.
- The installments can be monthly or quarterly and the pattern can be ‘Equated Monthly Installment’ or EMI or it can be principal repayment equivalent, which means the loan is repaid in equal amounts of principal.
- There can be many variations of a pre-determined payment pattern, the most common being the equal monthly installments or basic equivalent repayments.
The advantage of a term loan is that its structure is simple and well understood. The repayment obligation and frequency of repayment are known and the company can plan its cash flow to ensure regular repayment.
The drawback is that every business has its own peaks and troughs of cash flow. The term loan does not allow the company to change borrowing levels according to seasonal cash flows. Thus, you have to plan to get the largest amount of borrowing limit that you will use in the business cycle.
b) commercial overdraft
- These are the borrowing facilities where the lender, mostly the bank, sets a maximum limit on borrowing and the company can withdraw funds within the borrowing limit at any time and whenever required.
- Although the repayment is flexible as there are no fixed repayment patterns or installments, the bank usually expects the monthly or quarterly interest to be paid by the company periodically.
- A business credit card can also be considered a type of overdraft. These facilities are reviewed by the bank every year and are required to be renewed by the bank.
- Such a facility is offered by banks to customers who are considered to have good credit scores, also known as good credit risk.
The advantage of this arrangement is that the company can change its borrowing levels depending on seasonal cash flows.
The disadvantage is that the bank can redeem the loan at the annual loan review. This can happen if the bank is not satisfied with the regularity of repayment or if it is concerned about the business operations of the borrower.
c) Trade Finance
- This type of lending is related to the completion of commercial transactions. For example, the “Discounting Receivables” facility will be repaid upon receipt of the amount due from the Supply Chain Partner. Typically, the bank will set a revolving financial limit within which the total instruments receivable will be funded and must be repaid or withdrawn.
- These are short term loans by the lender.
- These can be in a variety of forms. For example, for billing or bill discounting, receivable discounting, merchant cash advances, among other forms.
The advantage of this facility is that it fits into everyday business transactions and, therefore, there is little unused money.
The disadvantage is that the company faces borrowing restrictions only when there is an essential supply chain transaction. If there is no transaction, then there is no lending. Thus this can only be used for managing working capital.
2. How much borrowing or borrowing limit do you need
Financial institutions make their own judgment about how much borrowing should be appropriate for the business. They use the working capital ratios and the company’s leverage ratios to arrive at a reasonable amount.
For companies, it is important that the amount required is calculated after carefully considering the operating cash flows of the company. It should not be too little (otherwise the business will have liquidity management problems) nor should it be too much (otherwise the business will be rejected by the bank as it may not meet its internal policies.)
The lender will assess your business loan application and determine the creditworthiness of your business based on the following factors:
a) Willingness to pay
The first checking point for a lending institution to assess the creditworthiness of your business is to analyze its track record of repaying previous loans in a timely manner.
The lender will consider the credit bureau scores and Corporate Credit Report (CRR) for your company’s payment history and only if the credit score of the borrower (sole owner, partner or company) is over the stipulated limit, proceed with the application process.
For a secured loan, which is a loan that requires the borrower to provide a guarantee, a credit score of over 600 is acceptable.
For an unsecured loan, this is a loan that does not require the borrower to provide a guarantee, a credit score of 700 and more is ideal.
Having a good credit score or CCR will not only open up more avenues for obtaining a loan, but can also positively affect the interest rate at which a business loan is extended.
New commercial borrowers are expected to build up their credit history gradually – starting with a small loan facility initially and then moving to larger facilities based on a good repayment history.
b) ability to pay
After establishing that the credit score is within the permissible level, the lender will assess the repayment ability of the borrower.
The lender will consider cash flows, profitability, stability, future prospects and other business parameters to assess the quantitative risk it is willing to take along with measuring the borrower’s ability to meet the EMI obligation.
A sound balance sheet can ensure your prospects for a business loan.
3. Guarantees or guarantees that the borrower can provide
Most lending institutions will require collateral to provide new business loans. Collateral can be a business asset (such as machinery) or the property of the business owner. While this is a basic requirement for a secured loan, an unsecured loan option is also available albeit at a higher interest rate.
There are a large number of businesses, especially unregulated ones, which may not be able to meet requirements such as guarantees and will be rejected by banks and most formal lending channels. Such companies can use alternative lenders who offer business loans without collateral.
Alternative lenders use digital information in the form of data from social, banking, and supply chain sources to build a business’s creditworthiness profile. They use machine learning algorithms, psychological assessment, and study demographic and cluster models to determine the granting of a loan to a small to medium enterprise.
Reference checks and document verification
The final stage of the evaluation process includes reference checks and document verification. The lender conducts reference checks with at least two of the Borrower’s supply chain partners along with validation of business documents submitted for evaluation. Checking or checking a negative reference can lead to an immediate rejection of the application.
Certain commercial facilities of the Bank may focus on selected industry sectors or borrowers. For example, textile machinery loans or loans to women entrepreneurs etc. If the applicant fits these criteria, the loan application will receive better treatment from the lender.
Business loans are indispensable in stimulating expansion and diversification in small businesses and large conglomerates alike.
For existing and new borrowers, getting a business loan is no longer a matter of luck. If the right procedures are followed, a business loan can help the borrower to start a new business, grow his existing business and meet his business requirements easily.