Decoding credit and loan terms for business owners

Decoding Credit and Loan Terms for Business Owners

Most companies eventually borrow money to fund operations and to finance business expansion. The terms in your loan agreement determine your interest rate, the term of your loan, and the monthly payment.

Review these loan and credit terms and concepts to understand the financial impact of a business loan.

Understanding the lender’s risk

To understand why certain loan terms are used, view the agreement from the lender’s perspective. Lenders are concerned about the risk of late loan payments and the risk that the borrower defaults on the loan.

Broadly speaking, there are two ways that lenders can minimize these risks:

  • Strong credit rating: The business has a history of borrowing and repaying loans on time. The company generates sufficient profits to make loan payments.
  • Collateral: The lender places a lien on company assets, giving the lender the right to keep possession of the asset until the debt is paid in full. If the borrower defaults, the lender takes ownership of the asset and can sell it to recover some or all of the loan proceeds.

Many assets, including accounts receivable, inventory, equipment, and real estate, may be used as loan collateral. Your loan agreement includes terms and conditions to minimize the lender’s risk.

Basic loan terms

If you’ve applied for personal loans, you’re familiar with these concepts:

Credit score

As mentioned above, the business credit score is used to determine if a company can repay the loan in full and on time. Firms that have used credit in the past and repaid on schedule have a higher score. 

Businesses that generate consistent earnings are in a better position to make loan payments. A higher credit score can lead to better loan terms and lower interest rates.

Business owners can request their Brightflow AI Business Credit Score and receive details about overall business health. The score details how fast your business is growing, the strength of your balance sheet, and the profitability of your business in the eyes of lenders.

Personal guarantees

Companies with inconsistent profits and firms that cannot offer sufficient collateral may struggle to obtain a loan. The founder may be asked to provide a personal guarantee to ensure that the loan is repaid.

Consider these two factors before you personally guarantee a company loan:

  • Liability: You are personally liable for repayment of the loan if your business can’t generate sufficient earnings to make payments. In some instances, company assets can be sold to repay a loan that is headed for default, which reduces your total loan liability.
  • Personal finances: A business loan guarantee impacts your personal credit score. Assume that you provide a personal guarantee on a $300,000 business loan. If you apply for a home mortgage, it will be more difficult to get the loan approved.

Finally, the personal guarantee puts pressure on the founder and may be a distraction from operating the business.

Interest rate

The interest rate may be a fixed or variable rate, and the type of interest rate charged impacts the total interest expense and payments.

Fixed rate loans make it easier to project payments. The business is provided a fixed schedule that discloses the principal and interest in each loan payment. A founder can include the loan payments in a business forecast and plan effectively.

The interest rate on a variable loan may change. Interest rates have increased sharply in recent years, and many business owners are paying higher interest rates. Higher rates increase loan payments, and business plans must be adjusted to reflect the change.

Loan term 

The term of the loan is the number of years that a loan is outstanding, and a longer loan term generates more interest expense over the life of the loan. 

Your loan term also impacts cash flow planning. Let’s assume that an eCommerce business is applying for a $50,000 loan to finance IT hardware and software. A three-year loan will require a larger monthly loan payment than a five-year loan. 

The owner needs to forecast how much more revenue the firm can generate after investing in additional IT. The additional revenue can help to fund higher loan payments.

Alternative loan agreements

Some lenders may be willing to approve loans that are less common. Here are two examples:

Revenue-based lending

With revenue-based lending, a lender provides capital to a business in exchange for a percentage of its future revenue. Instead of charging interest, the lender receives a percentage of the company’s gross revenue until the loan is repaid, often with a cap on the total amount paid back.

This type of loan restricts that amount of revenue available to pay other expenses. If your firm increases revenue by 40% in 12 months, a portion of the larger revenue total must pay down the loan.

Document against acceptance credit agreement (DACA)

These agreements are common in the importing business.

Assume that a U.S. sporting goods company is purchasing 200 bicycles from a French manufacturer. The bicycles have arrived in the U.S. and third-party shipper is storing the goods.

DACA is a time draft, or a promise to pay. The buyer provides the time draft, and a clearing bank releases documents to the buyer. The documents are provided to the third-party shipper, and the bicycles are released to the buyer.

The buyer does not pay the time draft in cash immediately, making the time draft a credit arrangement.

Simplified financial management

Loan agreements can be complex, and some owners may find it difficult to project the financial impact of different loan options.

Brightflow AI simplifies financial terms and management using automation. With Brightflow AI, owners can manage cash flows, access real-time reports, and monitor business health. Use Brightflow AI to make more informed financial decisions.

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