If you own a business, chances are that at some point your business could benefit from bank financing. Your company may be growing and need financing to meet increasing working capital needs or you may need to finance a new vehicle or equipment to be used in your operations. Whatever the case, it is helpful to have a basic understanding of some common business loan structures to help plan appropriately.
The types of loans people tend to be most familiar with are straight amortizing term loans, or loans that have a specific term and repayment period. Like a vehicle loan that many consumers have had at one point or another, these loans often have a fixed interest rate, a level monthly payment, and are designed to completely pay off over the term of the loan. Term loans are typically used to finance long-term depreciating assets such as vehicles, equipment or machinery and are usually offered with terms designed so that the repayment on the loan outpaces the decline in value of the asset. This will maintain flexibility in the company, allowing the asset to be sold if necessary, and also ensures that the bank always has sufficient collateral on the loan. For instance, an item with a short typical lifespan like electronics or computers might only be financed over a couple years while a vehicle or heavy equipment might be financed for a period of five years or more.
Another type of loan that can often be very useful to a company is a revolving line of credit. The goal of any business is typically to continually increase sales and revenue, but increasing revenue usually comes at a cost, and there often comes a time that a company doesn’t have the resources to continue to fund growing operations because of the burden growing accounts receivable or inventory place on cash flow. A revolving line of credit can be a very useful tool for a growing company to finance these short-term working capital needs in order to continue growing.
A line of credit will often be secured by the assets of the business, including any inventory and accounts receivable it may have. Some lines of credit, known as “formula based” or “borrowing base” lines of credit, will have a fluctuating credit limit that is based on a percentage of the company’s current level of receivables, inventory and/or equipment. These are common for larger lines of credit or lines to companies subject to substantial fluctuations in asset levels, due to seasonal or other cyclical forces. In these instances, the borrower will submit regular reports to the lender to certify that the balance on the line of credit doesn’t exceed the formula based credit limit outlined in the loan agreement.
Other lines of credit may be more informal and require only periodic financial statements submitted to the lender. Although your company may have a more informal line and may not be subject to frequent scrutiny of the line usage, you should still resist the temptation to use the line of credit for things other than short-term working capital needs. Banks often review business line activity periodically to ensure that the loan is being used for acceptable reasons and that the balance on the line fluctuates based on short-term business activity. A line that remains at a high balance is considered “evergreen” and may be a warning sign that the line is being used to finance long-term assets (better suited for a term loan), finance losses or finance excessive distributions to owners. If a bank notices that the line of credit is being used for purposes other than the intended purpose, it may be less likely to renew the loan under similar terms upon maturity.
Using bank financing responsibly can help ensure your business is well positioned to take advantage of profitable growth opportunities as they arise. Be sure to have an open dialogue with your banker about financing options if you foresee a possible need. Getting your banker involved early in the process will allow ample time to arrange the financing and ensure there are no surprises. QCBN
Written by Ryan Glennan
Country Bank is a full service community bank serving Yavapai County with offices in Prescott, Prescott Valley, and Cottonwood. Ryan Glennan, NMLS # 478327, is a vice president of Country Bank specializing in commercial lending and residential construction loans. Please visit www.countrybankaz.com or call 928-443-9595 for more information.