What are loans?
Loans are money that is lent to “deficit units” by the “surplus units” with the help of financial institution. The surplus units, also known as savers, lenders or investors, invest an amount to the financial institutions. They deposit funds into the banks that are then loaned out to the deficit units and they charge an interest on these loans.
The deficit units are known as the issuers of security, borrowers, and users of funds. They use these loans as a source of capital and make maximum use of them so that the surplus units can benefit from that.
Why small businesses need loans?
A small business is a business owned privately. It can be a partnership, sole proprietorship, or a private corporation. Such businesses have a small number of employees and make less annual revenue compared to the industry.
A small business needs loans to cover their day-to-day activities. These businesses rely on debt financing. This happens to be lower at cost of funds and provides a higher return on equity to the investors. The four main reasons why a small business needs loans are discussed below.
To Purchase real estate and expand operations
Banks lend money to existing firms that invest in real estate so that they can expand their operations. When firms want to expand, it gives off the impression to those banks that the business has been doing good and meeting their goals. The bank is assured that they are producing positive cash flows and will be doing that in the future too, thus causing the bank to approve these loans. Real estate loans are in the form of mortgage and are usually titled as long-term loans.
To purchase equipment
Purchasing equipment for a small business can be quite expensive, as they do not have excess cash that they can spend. Businesses can acquire equipment through purchase or by leasing it. Leasing does seem like a good option but does not provide the satisfaction of owning it. Banks usually provide businesses with intermediate-term loans that can be paid back within ten to fifteen years.
To purchase inventory
Inventory is very important for a small business. Such businesses need to have inventory to operate. Most of these businesses operate seasonally, meaning that if they do not have a certain type of inventory they can fail to break even. Small businesses may need a bank loan before the season to kick-start their operations.
To increase working capital
Working capital is the cash that is used on a day-to-day basis to run the business operations. The earning assets need to cover the working capital needs. For this to happen, a small business may need to apply for a loan. Banks and private lenders usually provide these loans and the business repays them through the profits they earn with the help of the loan. Banks/private lenders charge high interest on these loans since they are considered riskier.
Advantages and Disadvantages of Loans for Small Businesses
Advantages
1. Lower rates of interest. Loans are a hassle to obtain; however, private lenders can provide low interest on them with a good credit history attached. This allows entrepreneurs to get access to it easily.
2. Convenient and accessible. Banks and private lenders like to provide loans to new and growing businesses as they see potential in the future of the firm.
3. Multiple Loan Option. There are 101 types of loan schemes present for new and expanding businesses in the market.
Disadvantages
1. Long list of prerequisites to qualify for a loan. Getting a loan is not roses and rainbow. Before a bank grants you a loan, they have a long list that needs to be checked off. Most of the times it is hard for a small business to meet all the requirements set by the bank.
2. Risk of losing collateral. Bank and private lenders credits are for the most part endorsed against some “collateral” like for example the owner’s car. The owner can lose this to the bank if they fail to repay their loan.
3. Lengthy application process. Banks take ages to verify a loan. They literally leash a research on the business to know the firm from square one. The application of loan and fulfilment of the process takes a great amount of time and in the end, you may not even make it to the list!
Types of Loans that are useful for small businesses
- Micro loans
- Cash flow Loans
- Mission Driven Loans
- Online Marketplace Loans
- Business Credit Card
- Personal Sources