How to choose the right business loan: How to analyze and compare different business loan products

  • Business Loans
  • 4 Months ago
How to choose the right business loan
HIGHLIGHTS

  • Introduction
  • Overdraft facility or Working Capital Loans
  • Bank Overdraft


Introduction:

Capital is the most crucial factor that ensures the smooth running of activities in business organizations. Businesses, especially SMEs, often take business loans from banks/NBFCs to cover several running costs such as expenses towards premises, staff salary, inventory, equipment, etc. Banks/ NBFCs provide loans to enterprises with an operating history. 

SMEs that have a vision but are monetarily incapable can opt for different types of business loans mentioned below:

  • Overdraft facility or Working Capital requirements for covering day-to-day expenses;
  • Bank Overdraft;
  • Term Loan for business expansion;
  • To venture into a new line of business as a part of the future expansion;
  • For capital expenditure like buying a plant or machinery.

Now, let us discuss all heads in detail.

Overdraft facility or Working Capital Loans:

Banks primarily offer cash credit or overdraft facilities to finance the working capital needs. The working capital demand loans are carved out of the overdraft/cash credit facility.

The working capital cycle is the time taken by a business to convert the total net working capital (Current Assets minus Current Liabilities) into cash. Good business practices suggest managing this cycle by selling inventory quickly and speedily collecting the revenue from customers to help optimize the cash flow.

Businesses with positive cycles often require financing to cover the period before they receive payments from customers. To deal with this gap, companies often need financial loans provided by banks/NBFCs.

Bank Overdraft:

It is a form of loan that has no formal capital repayments. The business only has to make interest payments for the period that it has the loan. Interest is payable daily at a rate that fluctuates according to the bank’s base rate plus a mark-up (bank profit).

  •       This gives uncertainty over the cost- It will go up if interest rates go up. The interest paid is an allowable expense against the business profits.
  •       Annually renewed by the bank- The overdraft facility will be reviewed by the bank and a renewal fee will be charged annually.
  •       May involve fees- Usually, a bank will charge you a flat fee for selling up an overdraft according to a sliding scale- this would certainly be applicable for larger overdraft facilities.

Term Loans:

A term loan is a convenient medium-to-long-term loan instrument typically offered by banks as a medium-term loan ranging between one year to five years, whereas financial institutions may offer the term loan for up to seven to nine years depending upon the project requirements and cash flows. The loan tenure is also decided by the project requirements and project cash flows. Typically, determining factors include DSCR, total Debt Equity of the corporate, IRR and ERR of the project, etc.

Some of the features of term loans are as follows:

  • The business makes periodic payments so that the loan (capital) is reduced over the agreed term i.e. three, five, seven years, etc.
  • They can be long-term to cover the asset purchase and large start-up costs.
  • Interest is payable but the rate is usually fixed at the start of the loan tenure- this gives certainty to the business on the cost of the loan. The interest paid is an allowable expense against business profits.
  • There is an up-front arrangement fee, which again depends on the size of the loan, but no further ongoing costs.

Venture into a New Line of Business:

Every business starts with a vision, a dream of how to take the business to new heights. While the thought is always selfless, many companies falter when it comes to execution because of a limited understanding of managing finances.

In today’s dynamic scenario, plenty of options are available for raising funds to expand a new line of business. Business loans for new ventures are designed for various business situations with appropriate terms and conditions. Whether the new venture intends to bridge the working capital gap, or lease some new premises, this kind of credit will help achieve each of these objectives including capital requirements, financing needs, and operating expenses.

The benefits of obtaining a business loan to start a business venture are as follows:

  • Right Timing: - The key to a successful business is timing it right. And for the right timing, the owner needs to have the resources in place. Understanding this need, credits for new ventures or expanding a current one is designed as a business loan by the bank to disburse funds through a smooth process that only takes a few days.
  • Right Business Partner (i.e., Banks/NBFC): - While applying for a business loan, business owners have the opportunity to interact with professionally skilled and experienced lenders (i.e., Banks/NBFCs). These institutions have an in-depth understanding of business needs and offer valuable inputs in the areas of business often ignored by the owners.

If you are looking to expand a new line of business, obtaining a business loan could be one of the best financial decisions you can take.

Capital Expenditure: 

Industrial equipment is costly but very crucial for the operation and expansion of a business. Most banks offer loans for equipment purchase & machinery loans for new business, while some banks also have specialized products around construction equipment loans. However, when the business owner calculates the interest cost compared to hire purchase, or leasing of equipment, the cost of equipment buying can be on the higher side.

Hire purchase and leasing are the two ways of acquiring long-term assets including the machinery & equipment when the business does not wish to use a bank overdraft or term loan. It is also known as a collateral-free business loan. In this form, the owner can use the machinery loan without security. If a business owner wants to own the asset, then hiring a purchase is probably the most attractive option. It is essentially a term loan between two and five years at a fixed rate of interest. If the owner opts for a lease, then the owner is supposed to pay monthly charges to use an asset for an agreed period. At the end of the agreed period, the lessor is supposed to return the assets to the original owner.

This article presents a fair overview of business loan products available for business owners looking to expand their business. It covers different types of loans available in the money market to cater to the needs of every business.