Loan capital involves raising money to run your business from borrowing rather than from shares. Available in the form of bank loans, bank overdrafts and debentures, companies that obtain a working capital loan use the money to keep their company operating on a day-to-day basis and to contribute to their wider success and growth.
This is vital, as the power to borrow is of immense importance to all businesses. Whether to purchase stock, pay employees, keep up with specific costs or invest in growth, loan capital can be essential to stay afloat.
While it is more commonly used by new and start-up businesses because they don't have access to retained profits, it is also crucial to any company of any size or type.
Even as a profitable business, there may be times when you experience a shortfall and need to cover a cash flow issue, or wish to invest in growth. As such, loan capital must also be easy to access.
So is this method the best solution for your business' cash flow shortage? To answer this question, we've outlined the main advantages and disadvantages of loan capital for businesses.
Advantages of Loan Capital
As discussed, loan capital has a whole host of benefits over other forms of capital injection. Here are some of the most important:
Common Tool for Expansion
If you're looking to expand your business, then a business loan may be the ideal option for you. This can mean all the difference between taking your company's growth to the next level and being continuously stuck in a rut of mediocrity.
Perhaps you currently have one shop and are looking to have two, or have 50 employees but want to expand to hire more. Whatever the case, loan capital is an excellent tool used by many businesses that are looking to grow.
Flexibility and Speed of Lending
Even the most successful businesses can find themselves in cash flow difficulties. Short-term finance is mostly quicker to obtain and plugs the gaps when it's needed. For instance, if you have unexpected bills to pay, want to purchase new equipment to improve your business, have any unanticipated expenses or are experiencing a phase of rapid growth, a loan is the most flexible option to cover these expenses.
No Shares in the Business
Loan capital is not structured as a form of equity, but as a type of debt (in the form of a loan or cash advance). As such, when you take out a business loan, you do not need to give up a share of your business (as with equity), meaning you get to maintain complete control and ownership while at the same time benefiting from the assistance of financial aid.
While the lender monitors the performance of your business, they have no control over it. To contrast, shareholders expect a slice of the profits.
Loan capital is likely to have lower interest rates than an overdraft and, therefore, lower costs. With so many options to choose from, you can customise your bank loan to your specific business needs, agreeing on predefined repayment terms that make sense for your organisation, your budget and the predictive profitability of your business in the future.
You can decide on how long you are going to need to repay the loan back, as well as when you will repay each month (for instance on the first, second or third of each month, or the last day of the month). The beauty of loan capital is that you can tailor your loan based on what makes the most sense for you and your company.
Can Improve Your Credit Rating
If you take out a bank loan and make regular repayments, this can improve your credit rating, as the more you use loans, the more your credit rating improves. This will enable you to obtain further sources of finance in terms of long-term debt in the future. It will also help to build trust and cultivate a good relationship with the lender.
Increases Your Net Assets
Since bank loans are a long-term source of finance, this will be included in your statement of financial position (your balance sheet). As such, this will increase your net assets and, in turn, the net worth of your business. Furthermore, once loan capital is repaid, it will benefit to gain profit.
Disadvantages of Loan Capital
Before undertaking a business loan, it's essential to check the terms and conditions for late or non-payment, as penalties, rates and terms will differ from one loan to another. The following disadvantages typically apply to those who fail to pay back their loans:
When you take out a business loan, you must keep to the repayment terms that you agreed at the start of the loan. Failure to do so (also known as defaulting) can have a severe impact on your business financing going forward, such as the loss of assets to cover the costs of defaulting, which will impede your future financial options.
Assets May Be Taken
If you fail to repay your bank loan, your assets could be taken from you. This is particularly poignant if you have limited liability, as you are exposing yourself to possibly unnecessary risk. If you can't guarantee that you're going to make back the money, then you can't guarantee that you'll be able to make the repayments each month.
Can Negatively Affect Your Credit Rating
Failure to make your repayments back will worsen your credit score. Even a single late payment can damage your credit score while continuing to miss payments can increase the effect. If your credit score diminishes, it can be harder to get approval for other financial products, while you may be subject to higher interest rates on loans and credit cards.
Increases the Gearing of Your Business
Taking out a bank loan will increase the gearing of your business as you are taking on more long-term debt. Gearing, also known as leverage, helps to determine your company's creditworthiness and may be considered by lenders when deciding whether or not to extend their credit.
As you can see, using loan capital to fund your business is not without its disadvantages; however, there are times when almost every organisation will need one. Making the right decisions – for your business and your circumstances – is crucial, and can make all the difference between a beneficial, expedient business loan and a detrimental one.
What else should small business owners take into account when considering a loan? Let us know your thoughts in the comment section below!