When we are helping a client write a business plan, one of the major considerations is cash flow and the working capital that will be needed during the start-up phase of the business. New business owners are often unaware of the different types of loans available to them. This article will detail the types of loans and their proper usage.
The easiest way to differentiate between loans is the manner in which they are disbursed and repaid. A line of credit is very similar to a home equity loan: the business can request a disbursement when it needs the money and pay it back when they don't. There is no set repayment schedule and interest is charged based on the average balance each month. This type of loan is often used to smooth out differences between when a business receives money from its customers (accounts receivable terms) and when it pays money to its vendors (accounts payable terms). Some businesses have to buy their inventory in bulk at certain times of year and then sell it at a later date. Using a line of credit provides the business with the cash to pay for the inventory and still leaves operating funds while the inventory is sitting on the shelves. The key to successfully using a line of credit, is to pay it off when the inventory is sold and the money is collected for the sale. It is important to try and "rest" the line or pay it off in full periodically. Remember, the line is supposed to be for temporary, seasonal or short term cash needs.
Term loans are generally disbursed all at once and have a set repayment schedule involving interest and principal payments. This type of loan is used for longer term cash needs such as the purchase of equipment or real estate. The length of the loan or the repayment schedule should match the expected life of the asset being purchased. If you are buying equipment expected to last for five years, you would like to have it financed with a five year loan. This matching principal is common in the accounting world and really does help a business cash flow properly.
There may be times that the lender writes a loan with a shorter term than the repayment schedule which results in the need for either a balloon payment at the end of the loan's life (a large final payment) or a refinance of the remaining portion of the loan when the loan comes due. This does create some risk for the business as it must insure that it either has the money available to make the balloon payment or the ability to refinance the loan when the original loan comes due. Many businesses were caught short in 2009-2011 by loan structures such as this.
Having an understanding of the different types of loan structures is helpful to a small business owner so they know what type of loan to ask for and terms to negotiate for.