How to Get a Business Loan
Unless you are an accountant, or other financial services professional, you did not start a business to manage finances. You started because you have a passion for what you do - a burning desire to grow a successful business that grows and allows you to fulfil your ambitions.
Business loans are seen by many business owners as a way to change the trajectory of their business in both prosperous and uncertain times.Whether they are struggling to meet payroll or have recognised a unique market opportunity that they want to capitalise on, each scenario requires a cash injection. In fact, 2018 research by the Genesis Initiative revealed that almost 1 in 2 small businesses said they would be unable to grow their business without access to finance, with 86% already struggling to grow.
While the prospect of a business loan may seem daunting, you just never know when your business may need it so it’s always better to be prepared! In this blog, our aim is to uncover the fundamental aspects involved when small business owners like yourself first start to consider how to get a business loan.
DISCLAIMER: Always seek professional advice when making important financial decisions as they can have a significant impact on both you and your business.
Things to consider before you start your search
Why do you need a business loan?
High Street Banks, Alternative Lenders and Independent Finance providers will all require you to outline what you intend to use the business loan for, to ensure that it is intended for a business purpose. It is important to have clarity on this beforehand in order to make a strong business case for the lender, and convince them that you have a clear strategy in place to service the repayments. Common reasons for accessing finance include:
- pay off existing debts (e.g., other loans, invoices).
- buy new stock or machinery
- purchase a new facility
- refurbishment of premises
- cash flow / working capital
- expand existing business
- pay an upcoming tax bill
- property development
The more detail that you can show the lender, the greater your chances of securing funding. In particular, if it is for business development purposes, what is the potential return on investment (ROI) of the project?
As with any request for finance, the lender will need to know how much you need, how long you need the loan for, and how quickly you need it. This will vary greatly from business to business as each is completely different and should be determined after fully assessing your current financial situation:
- How much you need will depend on what you plan to use the finance for. If it is the purchase of a new asset for example, you will need to consider how much you have been quoted for the asset, the depreciation on the asset and its lifetime value.
- How long you need it for will require some analysis, as factors such as cashflow will determine how much you can repay each month and therefore what terms you can afford to commit to.
- The speed at which you need the loan will highlight to lenders how urgent the loan is, and perhaps indicate that you are struggling financially. Therefore, be careful of assuming that “faster is better” as it could result in a higher interest rate.
Always speak with a finance professional to find the option most suitable to your situation.
Types of business finance
The term ‘business loan’ tends to encompass all types of business finance. Many small businesses are not aware of just how many finance options exist in the market, so it is useful to understand the different types.
Asset Finance is a type of lending which allows a business to fund the purchase of assets or equipment, over an agreed period of time, with regular payments.
Bridging loans allow a business to lend a sum of money to cover the period of time between the processing of two transactions.Typically, the buying of one property and selling of another.
Unsecured business loans are a type of lending solution whereby a business can access finance without having to use personal or business assets as collateral. In other words, should the business be unable to repay the loan, the lender is not able to recover the losses by repossessing assets such as a house. Often, this means the interest rate is higher.
Secured business loans require a business to offer personal or business assets as collateral in exchange for the loan. If the business is unable to repay, the lender is entitled to repossess the asset.Interest rates are generally lower as a result, but this type of finance is much riskier, and businesses should not commit to it without careful consideration.
Invoice Finance allows businesses to borrow money against future invoices, or money owed to them by customers. These facilities tend to be used to improve cash flow.
Merchant Cash Advance gives a business an amount of money upfront in exchange for a portion of future card sales, plus interest.This is most suitable for businesses that take a significant percentage of their sales through card terminals.
Working Capital or Cash Flow Loans are a form of finance that is generally used to cover the day-to-day expenses of a business.These could be payroll, rent, utilities or other recurring expenses.
How does business loan interest work?
A business loan is generally lent to a business for use over an agreed time period, during which the business will repay both the principal (i.e., the amount borrowed) plus interest. Interest rates may be calculated on an annual or monthly basis.
For example, if your business were to borrow £50,000 over 1 year at an interest rate of 10%,you would repay £55,000 in total over 12 months:
10% of £50,000 = £5,000
£50,000 (principal) + £5,000 (interest) = £55,000
The above example assumes a fixed interest rate of 10%. However, a key thing to remember is that the interest rate can be fixed or variable.
Fixed Interest – the agreed interest rate does not change during the loan period. This makes it easier to calculate future payments.
Variable Interest – this kind of rate has the potential to change as it is tied to a benchmark (or index). If the benchmark rate changes, so does your interest rate. This could mean that you end up paying more to repay the loan than you originally thought.
Interest can also be calculated on a simple or compound basis:
Simple -assumes a flat % rate on the original loan amount over the loan term.
For example, if your business were to borrow £10,000 over 3 years at an interest rate of 10% per year, you would repay (£10,000 / 10%) £1,000 per year in interest. Over 3 years, the total repayment would be £13,000.
Compound– interest is calculated on the original loan amount, plus accumulated interest, and can be charged per day, month, year or quarter. At the end of each year, the interest that your business has accumulated is added to the original loan amount before the interest is calculated. For example:
At the end of year 1: (10,000 / 10) = £1000 (accumulated interest) + £10,000 (original amount). You would currently owe £11,000.
At the end of year 2: (11,000 / 10) = £1100 + £11,000.
You would currently owe £12,100.
At the end of year 3: (12,100 / 10) = £1210 + 12,100.
This equals a total repayment amount of £13,310.
On a compound basis, you would end up paying £310 more over the 3 years, which may appear to be a small figure. As you can imagine, the larger the loan value, the more this has an influence.
The lesson here is to make sure that you fully understand the terms that you are committing to beforehand, as interest rates can often be misleading.
What is APR and what does it include?
APR, or Annual Percentage Rate, is the industry standard rate used to help businesses and consumers understand the total cost of borrowing. It is expressed as a percentage and is calculated by taking the interest rate plus any additional costs or fees.
Other costs and fees to consider with business loans:
Arrangement. Fee - charged by the lender to cover the costs involved in the process of creating the loan. This tends to be added to the total that your business will repay and can be calculated either on the original loan fee, or on the original loan fee plus expected interest – in which case you would pay a higher fee. Always check with the lender beforehand.
Process or service fees – charged by the lender to cover the cost of managing the loan during the agreed term.
Exit Fees – some lenders will not charge an exit fee, but many will. This type of fee is more common in property development finance and is payable to the lender to close the loan facility. The amount may either be calculated as a percentage of the original loan amount, or the original amount plus interest. In terms of property, it could be calculated on the original loan value or the Gross Development Value (GDV) – i.e., the expected value of the property.
How to find the best business loan
Remember, to the lender, your business is a potential customer. They make money through the interest and other fees they charge on the business loan, so it is in their interest to provide you with the best rate in order to beat the competition. Of course, many factors contribute to the interest rate and terms that each lender can offer, with risk management & mitigation being their top priority.
‘Cheap and fast’ is not always best
Online comparison sites will match your business with funding providers based off very little information, which often lures businesses into thinking that the quotes they receive are tailored to them and “the best they can get”. In reality, these quotes are quite generic and perhaps do not offer solutions to the unique needs of your business. In many cases, the interest rates will be discounted to tempt you into committing but will rise significantly after a period of time.
Talk to a finance professional
As with any financial decision, it is essential that you consult with a professional beforehand to ensure that you are not putting yourself or your business at risk. This could be someone from your current bank, or an external financial advisor. They will be able to assess your business situation, and tailor their advice as a result.
Let a Commercial Finance Intermediary do the shopping for you…
Commercial Finance Intermediaries act as the middleman/woman between businesses looking for a business loan, and the variety of lenders that may be able to cater for their needs. They tend to be companies with vast experience in financial services and have the flexibility to search the market to find you the most suitable funding solution for your business’s unique requirements.
Keeping key documents to hand is a very useful first step to speed up the whole process, putting your application ahead of other businesses in the priority list of the lender. Let’s run through them.
- Business bank statements are a necessity for every lender, used to verify the income and expenditure of your business. They reflect your businesses spending habits and give the lender an initial view of your financial situation. But remember, bank statements do not tell the full story and the lender will need to dig a bit deeper to get a clearer view. They generally require 3 months to 12 months historical statements, which you can print off or download from your bank account.
- Financial accounts give the lender a longer-term overview of how your business is operating, on a year-by-year basis. Financial accounts will include information on turnover, the profitability of your business (through a profit & loss statement), and a balance sheet which shows the assets, liabilities and equity within your business. While these are not required in certain circumstances, they will significantly improve the likelihood of securing a business loan quickly.
- Management accounts are a set of financial statements, similar to the financial accounts, that are produced on a monthly or quarterly basis to reflect the current trading position. These give the lender a more up-to-date view of how your business is operating.
- Details of company directors will also be required during the application process including their name, address, when they became a director and other information.
- Proof of ID can be provided by showing a valid driving license or passport.
- Proof of Address can be provided by evidencing a utility bill or personal bank statement for example.
- Cash Flow Forecasts will be required by some lenders to evidence how you plan to repay the loan and what impact the loan will have on your business, whether that is extra revenue or the ability to pay off other debts for instance.
Think like a lender
Start by asking yourself, "if I were a lender, would I risk my money on this business?" Assess where you think your weak spots are, whether that is your business' credit score, existing debt or long receivables periods. Prepare yourself for the most difficult questions the lender may ask. Business loan eligibility is a complex subject with no standardised answer, but we’ll try our best to cover what the lender will be looking for.
Credit score (Personal & Business)
A credit score or rating reflects the likelihood of you repaying the debt. The higher the score, the better your chances of being approved for a business loan. Personal and business credit scores work in the same way, but generally personal scores range from 0-999, and business range from 0-100.Lenders tend to use Experian or Credit Safe scores to assess your application, so it is worth getting a free report from either of these sites. Remember, the lender will consider the business credit score, as well as the personal credit score of your company’s directors.
Lenders view loans that are backed by collateral as less risky, which could make it easier for you to get a loan with a lower interest rate. Collateral can include things such as a property, machinery or vehicles.DISCLAIMER: In the event that the debt cannot be repaid, the lender could repossess the asset used as collateral.
Ability to repay
The lender will look at what’s called a debt-to-income ratio(or debt/service ratio) during their assessment of your application. This figure represents how much net income your business is generating per month or year, in relation to the amount of debt you are asking for or have already.
Time in business
Each lender will have different requirements around how long your business needs to have been trading in order to get a loan. Generally speaking, the shorter the period, the riskier the business is to the lender as there will be less financial information to base the decision on. That’s not to say that there aren’t options out there as some companies will specialise in“start-up loans” for this exact reason.
Industry or Sector
Many small businesses do not realise that the industry they are operating in has an impact on the loan decision, which is completely out of their control. Lenders perceive certain sectors to be more or less risky than others based on factors such as the economy, politics, where they are currently invested and market analysis – among others.
It is impossible for a business to anticipate the risk-appetite of the lender, but the best you can do is prepare as best you can by collecting the relevant documentation. At Finative, we believe in responsible financial decisions and encourage all businesses to first check their cash flow to make sure they meet the minimum requirement necessary to service the loan.
Risks of taking out a business loan
So, hopefully by now you will have started to develop a good understanding of how to get a business loan and may even have an idea of what may be most appropriate for your business. Before you begin your search, we just want to recap some of the risks involved.
During the application process, you will be required to sign a director’s personal guarantee on the business loan. This agreement means that in the event that the business is unable to repay, you will be made personally liable for some or all of the debt.
Inability to repay
If you opt for a secured business loan, and offer a business or personal asset as collateral, that asset may be repossessed if you are unable to repay the debt.
Impact on Credit Score
Failure to repay debts, or late repayments, can have a negative impact on your business credit score. When you are searching for a business loan, make sure to check whether it is a ‘soft search’ or ‘hard search’. In other words, look out for a disclaimer that reads something like,“searching will not affect your credit score”, as this shows it is just a soft search.
When it comes to finding a business loan, there is no one-size-fits-all solution. While many small businesses right themselves off because they believe that you need a high credit score and X number of successful years trading, there is such a wide range of lenders available that your chances are much better. For instance, to some lenders a lower credit score could be offset by the fact that you have less existing debt than other businesses.
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