Before applying for a business loan, take time to think things through. Make sure you have a clear understanding of why you’re borrowing and how you’re going to put the funds to work. Clarity of purpose now will help you avoid trouble later. And purpose is crucial. There’s a loan for every purpose and matching your purpose and your resources with the right loan and repayment plan makes you a smart borrower.
How do you identify the right loan? Start with some basic questions:
What do you need the money for? Working capital? Inventory? Equipment? An acquisition? Real estate? Debt restructuring?
How much do you think you will need? When will you need the funds and for how long?
Will you repay the loan from cash flow as it comes in, or over time from net profits or retained earnings?
The answers to these questions will help you identify loan type and loan term.
Here are some common loan types and the purposes they serve best:
Short-term loans are made for short-term needs, including seasonal needs, and repayment is usually tied to cash flow from sales. A familiar example is the retailer who needs additional capital to build up inventory for the holidays. Short-term loans can also be used to fund the purchase of equipment.
Lines of credit offer an especially flexible avenue for meeting short-term financing needs. They provide a revolving source of credit and the maximum borrowing amount is set in advance. Once the line is set up, the borrower taps it as needed. Lines of credit are typically renewable annually. They may be secured or unsecured and the interest rate may be fixed or variable.
Intermediate-term loans (1-3 years) may help with more expensive equipment purchases. Defined repayment schedules and a maturity date are typical features. Repayment schedules often reflect the useful life of the item to be purchased.
Long-term financing (typically 3-10 years) is the preferred way to restructure a balance sheet, make an acquisition or execute a management buyout. These loans may include covenants designed to protect the borrower’s liquidity and ability to repay.
What lenders look for (and what you should look for, too) is a good match between sources and uses of funds.
What does this mean and why is it important?
What you want to avoid is a liquidity crunch, in which resources on hand aren’t enough to meet your obligations. This is something few small businesses can survive. And this is why your lender will be concerned about the structure of your balance sheet.
Because current assets (such as inventory) may fluctuate considerably, lenders will want to see they are financed by short-term debt and paid from cash flow.
The expectation for intermediate and long-term needs (real estate, for instance) is they will be financed by debt with similar terms and paid for out of profits.
When this is what your balance sheet shows, you can look more confidently to the future.
Lori Haney is senior vice president and Northern Nevada market manager at City National Bank.