Small businesses take out commercial bank loans for a variety of reasons. Loans can come from other sources as well. Credit unions make loans to small businesses. Loans can be made using accounts receivable or inventory as collateral. Borrowing money is expensive for a company and raises its risk. In addition to the risk of whatever enterprise you are undertaking, borrowing money introduces another level of risk to your company. Regardless, debt is one of the forms of financing small business operations. Here are four reasons that companies often use debt financing.
01 To Purchase Real Estate and Expand Operations
Banks are likely to loan money to existing firms that want to purchase real estate to expand their operations. If a firm is expanding, then the bank knows the firm is successful and it wants the firm to keep on doing what it’s doing. Expansion generally only happens if the firm is turning a profit and a positive cash flow and has positive forecasting numbers for the future. That is a scenario that makes a bank likely to approve a loan. Bank loans for real estate are usually in the form of a mortgage. Long-term bank loans are usually 25-30 year term loans. The real estate is used as collateral.
02 To Purchase Equipment
Businesses have a couple of choices with regard to the acquisition of equipment. They can buy it or they can lease it. There are good reasons to take out a loan to buy your equipment. You can take a tax write-off of #250,000 the first year you earn the equipment and depreciate the rest of the equipment over its economic life. You can also use the equipment for its life and sell it for a salvage value. In order to know whether it is best to buy or lease equipment, you should do a cost-benefit analysis before you make the decision. When a bank makes a loan for equipment, it is usually an intermediate term loan. Intermediate-term loans are generally 10-15 year term loans.
03 To Purchase Inventory
Banks sometimes make loans to small businesses to purchase inventory. Some small businesses are seasonal in nature, particularly retail businesses. If a business makes most of its sales during the holiday season, they want to purchase most of their inventory prior to the holiday season. They may need a bank loan prior to the holiday season to purchase a large amount of inventory to gear up for that time. Bank loans to purchase inventory are generally short-term in nature and companies usually pay them off after the season is over with the proceeds of sales from their seasonal sales.
04 To Increase Working Capital
Working capital is the money you use to manage your day-to-day operations. Small businesses sometimes need loans to meet their daily operations needs until their earning assets are sufficient to cover their working capital needs. Banks sometimes loan short-term money to small businesses to enable them to get off the ground and grow. As the business grows and their own assets enable them to earn money, they can repay the working capital loan to the bank. Working capital loans may have higher interest rates than, for example, real estate loans since banks consider them riskier.