Starting, running, and growing a small business requires money. Unless you have the resources to bootstrap your small business and keep it running and growing without the need to borrow funds, at some point, you may need to engage in some type of financing activity, which may include seeking a small business loan.
This article summarizes what you need to know to secure a small business loan to meet your current and future business needs.
Types of Small Business Loans
Like the small businesses they finance, small business loans come in a variety of types and are designed for different purposes. Common types of loans include:
- Fixed-term loans
- Equipment financing loans
- Credit lines
- Merchant cash advances
- Invoice factoring
- Commercial real estate loans
- Business credit cards
A common type of loan is the term loan where you receive a predetermined lump sum and then make payments of principal and interest on a fixed schedule. Typically, these loans require monthly payments. The rate of a term loan can be fixed or variable, which means it moves up or down under the terms of the loan. Typically, variable interest loans are tied to an index like the prime lending rate, so their interest rates increase or decrease as the prime lending rate fluctuates.
Equipment Financing Loans
An equipment financing loan is a type of term loan you can use to buy equipment or machinery — such as a tractor, computer, or kitchen appliance — that you need to operate your business. Because the equipment serves as collateral for the loan, small business owners can usually get an equipment loan even if their credit is not great. Many small businesses choose to lease.
Business Lines of Credit
Another common type of business funding is the business line of credit. This type of business loan works much like a credit card. A financial institution makes a certain amount of capital available for the borrower to draw from. Like other types of revolving credit, you can borrow up to the predetermined loan amount. As long as you pay the loan back on time with the agreed interest, you can continue to access funds up to the limit of your credit line.
Usually, business lines of credit don't have term limits, although some require you to go through a requalifying process to keep them open after a certain period. These credit lines can be secured with collateral, like your accounts receivable or inventory, or they can be unsecured, which means your promise to pay is all that's required.
Merchant Cash Advance Loans
Merchant cash advance loans are asset loans based on future sales. The lender and you agree on an amount for the loan, and you pay back a percentage of your sales to cover the loan plus fees. Transfers are made automatically out of your bank account to the lender. The cost of these loans can be quite high and are usually the last resort of a business owner who needs a short-term loan and/or an immediate infusion of cash for their business.
Invoice Financing Loan
Another avenue for cash-strapped business owners is the invoice financing loan. Also called invoice factoring, the business owners sell their unpaid invoices to the finance company at what usually amounts to a substantial discount.
Commercial Real Estate Loan
If you're looking to buy, refinance, or improve commercial real estate, consider a commercial real estate loan. Often, these loans are taken out when purchasing or developing an office building, retail center, or some other type of commercial building or group of buildings.
Business Credit Cards
Many small business owners start out with a business credit card to fund their startup, and established businesses often use them for other expenses. Interest rates can be on the higher end, but business credit cards can be useful on a short-term basis.
Small Business Administration Loans
The Small Business Administration (SBA) doesn't loan money to businesses directly, but partners with lenders to provide loans to small businesses. The purpose of the SBA's loan programs is to reduce risks for lenders so that small businesses can have more access to financing.
Most SBA loans fall under its 7(a) loan program. This program helps eligible small businesses purchase real estate, refinance business debt, purchase supplies and fixtures, and find long- and short-term working capital.
The SBA also administers the 504 loan program, which helps Certified Development Companies (CDCs) provide financing to companies promoting business growth and job development. The SBA's microloan program administers funds through eligible nonprofits to help small businesses and certain nonprofits with startup and expansion costs.
Where Can You Get a Small Business Loan?
Most people are familiar with direct business lenders, such as traditional banks, credit unions, and online lenders like Kabbage, Rapid Finance, and Fundera. These types of lenders don't require the involvement of a third party and often can offer access to SBA loan programs.
As an alternative to these loan options, you can turn to a peer-to-peer (P2P) lender. A P2P lender acts as an intermediary between the lenders — personal investors or institutions like investment banks or hedge funds — and the small business owner. For example, Funding Circle is a P2P lender that offers the opportunity to match your established business with different financing options, including term loans, lines of credit, and SBA loans.
Preparing to Apply for a Loan
The first step in the small business loan application process is determining how much funding you need. Next, you need to understand what the loan process requirements are and whether you meet the eligibility criteria. Last, you'll need good credit and be prepared to provide financial statements and other information and documentation needed for the application.
Determine Your Funding Needs
It's important to have a clear outline of your funding needs and assess your ability to meet the financial obligations of paying back the loan. For example, if you need to borrow $100,000 to finance inventory, you need to make sure you can produce the capital to pay back the loan.
You can determine how much money you can afford to borrow by calculating your debt-service coverage ratio (DSCR). Calculate your DSCR by dividing your net operating income by your total annual debt. To be attractive to most lenders, you will need a DSCR of at least 1.0. Here, assuming you have no other debt, you would need a minimum annual net operating income of $100,000 to borrow $100,000.
Know Your Credit Score
Before applying for small business financing, you'll want to order a copy of your credit report to examine your business and personal credit histories. Many small businesses don't have a business credit score. If that's the case, the lender will look at your personal credit score and will expect you to secure the business debt as personal debt.
While the minimum credit score needed to secure a business loan will vary, the higher your score, the better the repayment terms you'll receive from the lender. If you have a history of bad credit and your credit score is too low, you could be denied credit altogether.
You'll need to gather a lot of documentation to prove eligibility for most loan applications. The information is necessary to build a story around your business. Much of this will depend on keeping accurate accounting records and being able to produce documentation about your operations.
Typically, small business lenders will expect you to provide:
- Copies of your business bank account statements and personal bank statements
- Your business tax return
- Your personal tax return
- Business analysis and forecasts on cash flow and costs
- Information on accounts receivable and other business assets
- Information on current debt, including personal loans you've taken
- Your business licenses
- A business plan
- Credit score information, both business and personal
- Any other information of relevance to the lender, such as articles of incorporation, leases or other contracts, status as a minority- or woman-owned business.
Skynova Makes Loan-Related Record-Keeping Easy
No matter what type of business loan you apply for, approval hinges on good record-keeping and accounting practices. Skynova's accounting software helps small business owners easily manage their accounting and tax-related record-keeping. With Skynova's business templates and software solutions, you can spend less time on the financial aspects of your business and more time leveraging that loan to grow your business.
Notice to the Reader
The content within this article is a general guide and may not apply to your specific situation. Always consult with a professional accountant to ensure you're meeting accounting standards.