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A comprehensive guide to small business loans

Find out how small business loans can help you grow, the different types of loans that could be right for you, and how to qualify.

Finance your Business
BusinessFinancing

By Pipe July 18, 2023

Guide to small business loans

If you’re a small business owner, you probably already know that securing funding can be a major challenge. Without funding, you lose out on sales and opportunities for growth. If this resonates with you, it's time to consider small business loans.

Small business loans play a crucial role in providing entrepreneurs with the necessary financing to start or expand their businesses in ways that may otherwise be out of reach. Whether you're aiming to fuel growth, explore new ventures, or conquer immediate challenges, small business loans can be a game-changing solution.

In this article, we delve into the world of small business loans, covering everything you need to know:

  • Understanding small business loans

  • Types of small business loans

  • Assessing your needs

  • What you need to apply for a business loan

  • Evaluating your loan eligibility

  • Pros of small business loans

  • Cons of small business loans

Let’s dive in! (You won't fall, we’ll be holding your hands).

Understanding small business loans

Before going into the pros and cons of small business loans, we’ll begin by defining them. In its most basic form, a small business loan is a financial product designed to help small and medium-sized enterprises (SMEs) access capital to fund their businesses.

Small business loans serve as a lifeline for entrepreneurs, providing them with the capital needed to fund new projects, weather financial storms, acquire equipment, hire staff, purchase inventory, or expand operations.

They come in various forms, ranging from traditional loans to specialized financing products like SBA loans, lines of credit, equipment financing, and invoice financing. The primary advantage of these loans is that they provide companies with access to resources they would not otherwise have. By offering capital to SMEs, small business loans enable them to seize new opportunities, create jobs, and contribute to local economies.

They can be obtained from various sources, including traditional banks, credit unions, online lenders, and alternative financing providers. It's important to note, however, that each type of lender may have different eligibility criteria, loan terms, interest rates, and associated fees.

Types of small business loans

Small business loans come in various forms, each with its own advantages and considerations. Here are some of the most common types:

1. Term loans

These are traditional bank loans with a fixed repayment term, interest rate, and monthly payment. They are typically used for large projects or investments, such as equipment purchases or real estate acquisitions. Term loans can come from traditional banks, credit unions, or online lenders, and they often require collateral or a personal guarantee.

2. Business lines of credit

A business line of credit is a flexible loan option for small businesses. It allows you to quickly access a set amount of money whenever needed. Basically, they provide businesses with ongoing access to capital. They are suitable for managing short-term cash flow needs or unexpected expenses. Lines of credit can come from traditional banks, credit unions, or online lenders, and they often require collateral or a personal guarantee. Unlike a term loan, you only pay interest on the money you use. After a certain period, usually five years, you can no longer withdraw funds and must start repaying the loan.

3. SBA loans

These loans are backed by the Small Business Administration and are available through traditional lenders or online lenders. Unlike traditional loans, SBA loans have lower eligibility requirements and some collateralized types of SBA loans have longer repayment terms of up to 25 years. SBA loans can be used for a variety of purposes, including working capital, equipment purchases, and real estate acquisition. There are different types of SBA loans, each offering unique benefits and maximum loan limits. However, SBA loans generally range between $30,000 and $5 million. 

4. Merchant cash advance (MCA)

MCA is a type of business financing in which a lender provides a lump sum of capital to a company up front. Unlike traditional loans, repayment is linked to the business's future credit card or debit card revenue.

With each sale made and customer payment received through cards, a portion of that sale is directed to the lender to repay the advance. This repayment arrangement continues until the total advance, along with any agreed-upon fees, is fully paid off. It's important to note that the repayment timeline can vary based on the business's sales volume.

5. Equipment financing

From the name, it is clear that equipment financing is specifically designed to assist businesses in purchasing various types of equipment, including machinery, electronics, fixtures, and technology.

For small businesses, having the right equipment is essential for day-to-day operations. Without the necessary tools, companies may face decreased productivity, increased costs, and an inability to compete.

Beyond operational efficiency, it helps small businesses expand services, reach new customers, and increase revenue. Financing equipment preserves cash flow, allows access to new technology, and maintains competitiveness. Equipment financing offers tax benefits by deducting interest paid on loans,  reducing the overall tax burden and freeing up cash flow for your business.

The loan amount for equipment financing is typically based on the value of the item and the down payment provided by the borrower. They often come with more flexible repayment terms than traditional loans. SMEs can obtain equipment financing from traditional banks, credit unions, or online lenders, and the equipment itself may serve as collateral.

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Assessing your needs–do you need a business loan?

Before applying for a small business loan, it's important to evaluate your company’s needs and determine what type of loan would be the best fit. This seems obvious enough, except it isn’t.

As a general rule, remember two important points before taking a loan for your business: first, only take a loan when it helps you seize opportunities to increase revenue and grow your business. Second, avoid relying on a loan to keep a failing business afloat. Here are some factors to consider when assessing your funding needs:

1. Determining the loan amount

The first step in assessing your business’s needs is to determine how much money you require. Consider whether you are seeking funding for a new project, expanding your product line, or covering current expenses.

It's important to assess both your short-term and long-term financial goals when determining the loan amount. Striking the right balance is important—borrowing too little may leave you short on funds while borrowing too much can lead to unnecessary debt burdens.

One way to determine the loan amount is to create a detailed budget that outlines all of your expenses and revenue projections. This will give you a clear picture of your financial needs and help you make an informed decision about the loan amount.

2. Identifying the purpose of the loan

Knowing what you want to accomplish with your loan is just as important as knowing how much cash you require. Are you looking to expand your business, cover expenses during a slow season, or finance a specific project?

For instance, if you're looking to expand your business, you may need a more significant loan amount and a longer repayment term. On the other hand, if you're looking to cover expenses during a slow season, a short-term loan may be more appropriate.

It's also important to consider the potential return on investment (ROI) of the loan. Will the loan help you generate more revenue or increase your profitability? If so, it may be worth borrowing the money.

Ultimately, identifying the purpose of the loan will help you choose the right loan product and ensure that you're using the funds wisely.

What you need to apply for a business loan; preparing essential documents

Applying for a business loan can be an exciting step towards achieving your goals. Before applying for a small business loan, it's essential to prepare yourself and your business by gathering all the necessary documents to support your application. This step can help you overcome common hurdles and improve your chances of getting financing. Here's a simple guide to help you prepare:

  • Business information: You’d want to provide basic details about your business. Include your business's legal name, address, and contact information. Provide an overview of your industry and specify the number of years your company has been operating. If you have partners or investors, you’ll likely need information for each owner of the business. Additionally, explain the purpose of the loan and how it will contribute to your business's growth and success.

  • Financial statements: When applying for a small business loan, lenders want to see your company’s financial statements, including income statements, cash flow statements, and balance sheets. These documents provide an overview of your business’s financial health and help lenders evaluate your ability to repay the loan.

Make sure your financial statements are accurate, up-to-date, and prepared by a certified public accountant (CPA). If you don't have a CPA, consider hiring one to prepare your financial statements. A CPA can also provide valuable advice on improving your financial performance and increasing your chances of getting approved for a loan.

  • Tax returns: Lenders will also ask for personal and business tax returns to evaluate your financial stability. Be sure to have copies of these documents and ensure they are up-to-date. If you haven't filed your tax returns yet, do so before applying for a loan.

If you have any outstanding tax liabilities, make sure to address them before applying for a loan. Lenders will be hesitant to approve your loan if you have any unresolved tax issues. Make sure to have your business tax returns for the past few years ready. This helps lenders assess your financial stability and verify your income.

  • Business plan: Crafting a strong business plan is crucial. It outlines your company's history, goals, projected cash flow, target market, competitors, and marketing strategy. A well-written plan enhances lenders' understanding of your business and boosts the chances of a favorable loan evaluation.

Include a comprehensive market analysis in your plan, highlighting your target customers' needs and how your offerings meet them. Add a detailed financial plan projecting revenue, expenses, and profits for the next few years, along with a break-even analysis. A well-crafted plan showcases your vision, strategy, and growth potential. It helps lenders grasp your business and shows them how you'll maximize the loan. Your accountant can help you prepare these as well.

  • Personal credit information: Lenders often consider personal credit history, especially for small businesses. Be prepared to provide your credit score and any information about past bankruptcies or foreclosures.

  • Collateral details: If you have collateral to secure the loan, such as property or equipment, have documentation ready to demonstrate its value and ownership.

  • Legal documents: Depending on the type of loan you are pursuing, you might need to provide legal documents such as articles of incorporation, business licenses, or commercial leases. Be sure to check with your lender for specific requirements and make sure you have all the necessary documents ready.

Being prepared can help streamline the loan application process and increase your chances of getting approved for a loan. Make sure to evaluate your options carefully, weigh the benefits and drawbacks of each type of loan, and choose the one that best aligns with your needs and goals.

Certainly, all this is a lot to take in. However, remember, we're here to guide you through the process and answer any questions you may have.

Evaluating your loan eligibility

Lenders assess your loan application based on various factors. Familiarizing yourself with these factors can help you choose the appropriate loan and lender. Here are some aspects to consider:

1. Credit scores: personal and business

It's no surprise that lenders rely on your past credit performance to assess your ability to handle new credit. They primarily consider two key factors: your personal credit score and your business credit score. These scores provide valuable insights into your creditworthiness and help lenders gauge the level of risk involved in extending credit to you.

  • Personal credit score: Lenders often conduct a personal credit check. Therefore, it's important to pay attention to your personal credit score beforehand. A credit score ranges from 300 to 850 and reflects your credit history. Scores above 700 are considered excellent, increasing approval chances. Scores in the mid-600s may be acceptable but expect higher interest rates and stricter terms.

So how do you get that high credit score lenders want? Nobody knows the exact algorithms that determine your FICO credit score (except FICO, of course), but we know the factors: your payment history, how much you owe, how much new credit you have, how long you’ve had credit, your debt-to-limit ratio, and the diversity of your credit history.

Improve those factors to boost your score–make timely payments, reduce the debt-to-income ratio, and limit credit inquiries. Regularly monitor your score and correct any errors.

  • Business credit score: Established businesses should have a business credit score. Many business owners are surprised to find out that they do. Similar to personal credit scores, business credit scores use different formulas and a score of 100 indicates excellent creditworthiness. Scores above 80 are strong and enhance approval chances.

To improve your business credit, start by making sure your business has a name, legal entity, and an employer identification number (EIN) from the IRS, and that it is registered and qualified to do business in the state(s) you operate in.

Also, ensure you're paying bills on time, maintaining a low debt-to-income ratio, and building a positive credit history. As you get credit and loans, pay them off on time. Then watch your credit score climb.

You should also open a business-specific bank account and get a D-U-N-S number. A D-U-N-S Number, short for Data Universal Numbering System, is a unique nine-digit identifier for businesses provided by Dun & Bradstreet. It serves as a powerful tool that distinguishes your business, opening doors to better credit opportunities, partnerships, and enhanced credibility. Think of it as your business's distinct digital fingerprint, helping others trust, identify, and engage with your company confidently.

Maintaining a good credit standing shows your financial responsibility and enhances the likelihood of securing the necessary financing for your business. If your credit history needs improvement, don't worry—we can provide guidance on how to enhance your credit profile.

2. Time in business

When applying for a business loan, know that lenders often prefer working with businesses that have a solid track record of operating for a certain period, typically around six months to a year. This showcases your business's stability and proven ability to effectively manage day-to-day operations.

As a general rule, the longer you have been operating, the greater the opportunities for obtaining financing. While most lenders want historical performance to evaluate, there are specialized loan options tailored for startups that are worth exploring.

3. Revenue and profitability

Lenders will carefully evaluate your business's revenue and profitability to assess its financial health. While specific requirements may vary, having a consistent revenue stream and demonstrating profitability can significantly increase your chances of qualifying for a loan. Showing that your business generates a steady income highlights its potential for growth and success.

4. Cash flow

When lenders assess your cash flow, they want to understand more than just your business's revenue. Positive cash flow indicates that your business generates sufficient income to cover its expenses and loan repayments. Demonstrating a healthy cash flow reassures lenders of your ability to manage loan obligations, thus enhancing your eligibility.

5. Debt-to-income ratio

The debt-to-income ratio, also known as your debt load, is a key factor that lenders consider. This ratio compares your total debts to your income. A lower ratio signifies a healthier financial position and can improve your eligibility for a business loan. Maintaining manageable debt relative to your income showcases your responsible handling of financial obligations.

6. Industry and collateral

In certain cases, lenders may take into account the industry in which your business operates. Some industries may be perceived as having higher risks due to market volatility or other factors. Additionally, offering collateral, such as property or equipment, can provide added security for the loan and potentially enhance your eligibility. 

Pros of small business loans

Small businesses are the backbone of the economy, and they play a vital role in job creation and economic growth. However, starting or expanding a small business can be a daunting task, especially when it comes to financing. That's where small business loans come in. Small business loans offer a variety of benefits to entrepreneurs, including:

1. Access to capital

Access to capital is one of the primary benefits of small business loans. As any entrepreneur knows, starting or expanding a business requires a significant up-front investment. Small business loans provide companies with the capital they need to get off the ground, purchase inventory, or invest in new technology. This is particularly valuable for businesses that are just starting out or looking to grow.

2. Flexibility in loan terms

Compared to traditional loans, small business loans often come with more flexible terms. These may include longer repayment periods and reduced monthly payments. Such flexibility helps businesses manage their cash flow and avoid overextension. Additionally, some lenders will offer small business loans with no prepayment penalty, allowing companies to pay off their debt early and save on interest costs.

3. Build business credit

Small business loans can also help entrepreneurs build their business credit. By making timely payments on their loans, entrepreneurs can bolster their business credit, increasing their chances of securing future financing. Good credit can also help businesses secure lower interest rates and better loan terms in the future.

4. Tax benefits

Small business owners can also enjoy certain tax benefits when they take out a loan. The interest paid on a small business loan is typically tax-deductible, reducing the overall cost of borrowing. Additionally, some lenders may be willing to work with business owners to structure loan terms in a way that maximizes tax benefits. This can be a significant advantage for small businesses, especially those that are just starting out.

5. Retain ownership

Small business loans are non-dilutive, allowing entrepreneurs to access capital without sacrificing ownership. Unlike equity financing, where owners must sell a portion of their business to investors, small business loans offer companies the opportunity to borrow money without relinquishing control. This can be particularly appealing for entrepreneurs who want to maintain control over their company's operations and decision-making.

Overall, small business loans offer a variety of benefits to entrepreneurs. From access to capital to tax benefits and more flexible loan terms, small business loans can help businesses achieve their goals and grow. If you're a small business owner, it's worth considering a small business loan as a financing option.

Potential drawbacks of small business loans

While small business loans can offer much-needed funding for companies seeking growth and expansion, it's essential to be aware of the potential downsides before proceeding. Here are some key details to keep in mind:

1. Debt accumulation

One of the primary downsides of small business loans is that they can lead to significant debt accumulation. This can be particularly problematic for businesses that are unable to generate sufficient revenues to cover their debt payments. Companies that borrow more than they can afford to repay may be forced to downsize or even close their doors.

It's important for businesses to carefully evaluate their financial situation and borrowing needs before taking out a loan. Consider factors such as their current revenue, projected growth, and ability to make loan payments on time.

2. Collateral requirements

Many lenders require collateral to secure a small business loan. Collateral can take the form of real estate, equipment, or other assets. In the event of loan default, the lender can seize the collateral, which can be devastating for businesses that heavily rely on their assets.

You want to carefully review the terms and conditions of any loan agreement before signing on the dotted line. You may also want to consider alternative financing options, which may not require collateral.

3. Interest rates and fees

Small business loans often come with higher interest rates and fees compared to traditional loans. This can make them more expensive for companies to borrow, especially if they are unable to obtain favorable loan terms. Additionally, some lenders may charge hidden fees or penalties, such as prepayment penalties or late fees, which can add up quickly.

It’s always best to compare loan offers from multiple lenders to find the best rates and terms for you. Also, keep an eye out so that you’re aware of any additional fees or charges associated with the loan.

4. Strict eligibility criteria

Small business loans often have strict eligibility requirements, making them difficult to obtain. Lenders may require companies to have a certain revenue or credit score or to have been in business for a certain amount of time. Businesses that do not meet these eligibility criteria may struggle to obtain financing.

To cut to the chase and prevent wasted efforts, you want to review the eligibility criteria for any loan you’re considering and ensure that you and your business meet the requirements before applying. Again, exploring alternative financing options such as grants or loans from non-traditional lenders is always an option.

5. Impact on cash flow

Taking on a small business loan can affect a company's cash flow. Because loan payments must be made on a regular basis, businesses may find themselves with less money to invest in other areas of their operations. This can make it difficult for companies to take advantage of new opportunities or respond to unexpected events.

To navigate this challenge, carefully evaluate your cash flow and budget prior to taking out a loan. Also, consider the potential impact of loan payments on your ability to invest in other areas of your company’s operations.

Overall, small business loans can be a valuable tool for companies looking to grow and expand. However, it's important that you weigh the pros against the cons before making a decision.

Conclusion

Small business loans can provide entrepreneurs with the financing they need to start or grow their businesses. However, it's important to consider the potential drawbacks involved and their impact on cash flow. By carefully evaluating both the benefits and challenges, you can make informed decisions and leverage loans as a powerful tool for your growth and success.

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