Understanding How to Borrow Money To Finance Your Business¹
At some point during the life of a business, many small business owners need to borrow funds. The most common uses of borrowing money, also known as financing, would be to start a business, expand a business, or use borrowed funds to help the business with ongoing expenses. There are essentially two types of financing that small businesses seek: Short Term and Long Term financing.
Short Term Financing
Short Term Financing is money borrowed for a short amount of time, from around one month to around two years. The most common reasons why a small business would seek short term financing are to assist with ongoing operations such as payroll and accounts payable. They use this money because they expect to generate more revenue in the near future to take over paying the obligations that the financing is currently needed for. It could also be used to purchase inventory or supplies during the slow season to prepare for the major sales season, such as Christmas for retailers or the spring for landscapers.
Short term financing can be procured from many different lending institutions which have their own policies and regulations. Most short term loans have higher payment amounts because the loan must be paid back in a shorter period of time. On the other hand, the interest rates are usually much lower because of that same short time span of the loan. The lending institution is also not as concerned about the lower interest rate because the loan will not be outstanding for an extended period of time. For example, if they gave you a short term loan at 5% interest that is due within 6 months and interest rates rise to 8% in month 4 then the bank knows that it only has cash tied up in a lower interest rate loan for only a couple more months.
Long Term Financing
Long Term Financing is money borrowed for a longer period of time, most likely for two years or longer. The more common reasons why a small business would seek long term financing are for major capital projects such as the construction of a new building, major equipment purchases, and expansion projects.
These businesses seek out long term financing because their cash flow from ongoing operations would not normally be able to fund these major projects in a short period of time, however, the business does anticipate being able to pay it back from ongoing operations over a long period of time.
Just like short term financing, long term financing can be procured from many different lending institutions which have their own policies and regulations. Typically, a long term loan will have lower payment amounts than a short term loan because the loan can be paid back over an extended amount of time.
However, because of this the lending institution, over the life of the loan, will receive a greater amount of interest. Interest rates will also be slightly higher because the lending institution wants to hedge itself against the possibility that rates will rise. The bank doesn’t want to have as much cash tied up in a loan that is generating less interest than it could get from another borrower.
When deciding on whether to give a loan to a potential borrower, a typical lending institution will look at what is known as the “Five C’s of Lending”: Character, Capacity, Capital, Conditions, and Collateral.
Character: It is important for the lending institution to determine your character because they are lending you a lot of funds and the bank wants to ensure that they will get paid back. That is the bank’s primary concern. They will look at the track record of the borrower to see how well they have met previous obligations.
Capacity: This revolves around whether or not the business has the ability, or capacity, to pay back the loan. Just because the borrower has a solid character, the lending institution wants to make sure that what they want to borrow money for has the ability to pay them back. Is the idea and plans to execute the idea solid?
Capital: Lenders tend to favor business owners who are invested themselves, financially, in the business. If the entirety of the risk is on the bank then it is much easier for a business owner to simply walk away. The bank wants to ensure the owner has a vested financial commitment to the business.
Conditions: This revolves around the actual conditions of the market or industry and not necessarily directly related to the borrower’s business. The lending institution will look at whether or not the market conditions are favorable for the business being able to pay back the loan. For example, if the business seeking a loan is an auto dealership that sells trucks and SUVs and there has recently been a major spike in gas prices, the lending institution might think the conditions are not favorable to lend money to this business because the market for gas-guzzling vehicles might shrink.
Collateral: Collateral is simply an asset that the lending institution gets to assume control over if the borrower does not pay the loan back. A common example is with automobiles that are financed at the dealership. If a borrower does not pay back the loan then the dealership would have used the car itself as collateral and can then repossess the car. Many businesses could pledge their real estate, equipment, or inventory as collateral.
Whether you are seeking to borrow using short term or long term financing, it is important you understand the Five C’s of Lending. Before initially speaking with your lending institution, ask yourself if you were a bank would you lend yourself money? Borrowing money is no easy decision, however, if done with prudence it would be a win-win for both your business and your lending institution.