Whether funds are required to set the foundations for a start-up business, inject some cash into the business to continue to operate or even grow, the most common method of funding for small and medium-sized organisations (SME) is bank loans. Much like a personal loan, a bank loan for SMEs will come with monthly repayments you’ll be responsible for each month. Failure to do so, could result in your business and personal assets being at risk depending on how you’ve set up your business structure.
If you’re confident that borrowing money is right for you, however, and that doing so will bring in more revenue and sales for your business, then it can be a great option to give your business the cash injection it needs to carry out your business plan effectively.
Businesses will need to evaluate the strengths and weaknesses of this type of funding, however, and this article will provide valuable information to support this decision.
What Are SMEs And Why Do They Consider Bank Loans?
In the UK, SMEs make up 99% of all businesses’ and are categorised as organisations with less than 500 employees. There are 6 million types of SMEs in the UK which represent various industries such as manufacturing and technology.
Bank loans can be used for a wide range of activities within the organisation like buying or maintaining equipment, purchasing stock or managing cash flow. This can be a useful funding source for organisations as it provides a cash balance upfront – along with tax benefits – that can then be repaid by scheduled payments over a fixed duration.
Think of it as being similar to a mortgage. In your personal life, you might approach a mortgage lender to borrow money to buy a house. Each month you’ll be responsible for making repayments. Those repayments will cover the capital of the loan (the mortgage balance – the amount you actually borrowed), but you’ll also pay interest. In fixed rate mortgages this could by set for 2, 5, or 10 years, but there are other deals which can be found that means interest rates fluctuate depending on the mortgage terms.
Well, a bank loan for SMEs is similar. You’ll have a loan term (how long you have to repay), set interest rates, and a loan amount all agreed before you borrow. They’re different to other types of lending banks use for businesses such as working capital loans, asset financing, and invoice financing which all allow businesses to borrow in a much more immediate sense for short term cash flow issues.
For a more managed, carefully considered approach, traditional business bank loans are usually the best way to go.
Bank Loans are typically used by SME’s for:
- Purchase stock or materials
- Facility development
- Hiring further resource
- Advertising
- Managing cash flow shortages
- Debt consolidation
What Are The Main Advantages Of Bank Loans For SMEs?
Access To Capital
The main advantage of bank loans is instant credit, making raising capital a breeze. This allows the organisation to maintain the operation in times of hardship or invest money into the business which may otherwise need to be ring fenced for other priorities.
Cash could then be used for maximising any investment opportunities in the market that could be profitable and allow the SME to expand operations. Investing in additional products or creating further sales channels such as an ecommerce platform are good examples of this.
For SMEs, having access to a bank loan can provide financial relief in case of any periods of low sales, product issues or supply chain disruptions. This allows operations to continue without any further interruption. It also means as a business owner you won’t need to risk spending your personal finance to keep your business afloat.
In some cases, the additional cash will be used to facilitate growth by implementing strategies to increase profitability without having to delay until the business has accumulated enough funds to proceed.
Lower Interest Rates
A key advantage with bank loans in comparison to other lending methods, such as credit cards, is interest rates typically range from between 4%-10% – as opposed to 25% for credit cards. The lower the interest rate, the smaller the repayment obligation meaning less to repay to satisfy the loan which can increase profits.
If your business loan is for assets or property, then you should be aware of additional costs such as deposit, arrangement and valuation fees. Whilst usually only small fees, they do add up so it’s worth considering how that impacts the benefit of lower rates.
Fixed Monthly Payments
Bank Loans are usually repaid through fixed monthly payments. This follows an agreed schedule and allows a business to adequately plan their budget as forecasts will be more accurate due to operational ongoing expenses being more predictable.
The fixed nature of the bank loan repayments prevents any unbudgeted amounts being requested. This can provide significant benefit to a SME as it will help maintain cash flow and allow for more accurate financial planning. With other credit lenders, things like changes in interest rate can cause a spike in repayment amounts impacting the SME negatively.
Potential Tax Benefits
In most cases, interest paid back on a bank loan can be deducted from the SMEs tax liability. This can incentivise borrowing for SMEs and allow for further growth, however, due to the changing landscape of UK tax law, SMEs should consult tax professionals before committing to a loan.
Build Business Credit
To secure future financing, businesses need to build a good credit profile. By meeting an agreed payment schedule, this will show an SME’s creditworthiness and help in any future credit applications.
Further benefits such as lower interest rates on loan repayments can be achieved if an SME has a good credit profile. They will be viewed as trustworthy, lowering the bank’s risk and allowing them to provide favourable interest rates for the SME.
Enable Larger Investments
The capital received from a bank loan provides a lump sum for investment that can create growth in the company and lead to higher revenue and subsequently higher profits.
Lump sums from the bank loan, can help SMEs make investment in the organisation that otherwise might not have been achievable. Often, large investments in equipment and infrastructure provide higher returns and create further opportunities that justifies the application for credit.
What Are The Main Disadvantages Of Bank Loans For SMEs?
Unfortunately, there are also disadvantages for SMEs when considering a bank loan:
Debt Burden
Having a high debt level can cause disruption within a business. If kept manageable, it can lead to many advantages. However, should the debt level become too high, it can put pressure on an SME’s operations if unable to cover the repayments. It also doesn’t allow for any flexibility of budget in case extra funds are required for other priorities.
It’s a similar situation to where negative equity is present on a home loan. Being unable to cover your debts can lead to a lack of trust, not just from your current lender, but all future potential lenders, too.
Each SME should carefully consider their ability to make repayments in the worst-case scenario before committing to the loan.
Strict Eligibility Requirements
New SMEs can have trouble in the early years meeting the strict criteria – such as a good credit history and a consistently strong turnover – that many banks require before approving a bank loan.
A record of consistent sales & other financial documentation may be required for a specific number of years and depending on the length of time a SME has been operating, this could prove difficult to provide.
Potential Collateral Requirements
Sometimes SMEs will be required to secure collateral – such as property or equipment – against the bank loan. This can add huge risk to an SME’s business. If SME defaults against the loan by not making repayments, the bank can seize whatever collateral has been secured against the loan.
Securing collateral against a bank loan can deter SMEs from this type of financing due to increased risk other than just a poor credit rating, but potentially losing the very things they need to do business in the first place.
Changing Interest Rates
Interest rates play a key part in determining if businesses should commit to the loan.
If the SME decides on a fixed loan, this can give certainty around repayment rates, allow more accurate forecasting and remove risk of default because of any unexpected price increases.
However, should the SME opt for a variable rate bank loan, this can expose them to interest rate spikes that can mean higher loan repayments, leading to default or other negative impacts to an operation.
Penalties And Fees
Breaking any of the terms of the loan agreement could lead to financial penalties being imposed which adds to the cost of borrowing.
Fees incurred because of late payments will be added to loan balance, which if not carefully monitored, can quickly escalate and cause serious cash flow issues for SME.
Impact On Credit Score
To gain access to credit, a good credit score is required.
For SMEs who have payment defaults or a low credit score, gaining access to credit can be hard. It usually results in loans having a higher borrowing rate, meaning more expensive to SME. This issue can be long lasting.
Secured vs Unsecured Business Loans
There is one main difference between secured and unsecured loans – collateral!
Secured Loans
Secured loans require collateral – such as property or equipment – to be put up so that in case of default, the bank can seize assets. This allows banks to offer companies:
- Lower interest rates
- Larger loan amounts
- Larger amounts of credit available
- Enhanced repayment terms
However, should the SME default on repayments, they risk having their assets seized.
Some SMEs are willing to accept the risk of losing collateral for more favourable terms although assets essential for business operation should not be used to secure the loan if possible.
Unsecured Loans
Unsecured loans require no backing and are approved based on credit score and as a result:
- Have higher interest rates
- Lower credit amounts
- Shorter repayment terms
The benefit of unsecured loans is no collateral is required. This is a better option for SMEs if they lack, or are reluctant to provide, equipment essential to their operation. Each loan should be evaluated before committing to a decision.
How SMEs Can Make Informed Loan Decisions
There are a variety of areas SMEs need to consider when deciding what is best for their business. The key areas are:
Consult Advisors
Consulting experts before committing to a loan is a sensible option for SMEs. Advisors will help representatives of the SME assess impact on finances and provide insights which should help SME make more informed choices.
Evaluate Finances
Performing due diligence on business finances will provide valuable information in determining whether additional debt is manageable, and SME can support repayments. By reviewing financial projections against expected growth, it should provide enough information to determine if taking a loan is in the best interests of the organisation.
Compare Loan Options
Different lenders offer a range of bank loans with different terms and interest rates. It is important that the SME compare alternative options to make sure they get possible rates.
Read Loan Agreements
Understand all loan obligations and the impact it will have before signing any agreement. If necessary, ask for clarification from lenders. Vague wording on contracts can lead to confusion so it’s worth taking time to be clear.
Consider Alternatives
There may be alternatives to bank loans, such as grants, and it’s worth exploring suitable alternatives before deciding to commit to a loan.
Build Contingencies
Putting contingency plans in place for unexpected costs, will help manage risk of missed payments. If deviating from the plan, steps can be taken to correct and minimise business impact.
Conclusion: Advantage And Disadvantage Of Bank Loan Borrowing
For an SME to grow, additional finance will likely be required at some point, but SMEs must be comfortable that loan obligations can be met while maintaining the day-to-day business operations.
Consulting with professional advisors can help SMEs determine if the bank loan is worth the risk for future growth by looking at financial projections, their risk tolerance and providing advice.
Additional capital ensures SMEs can seize on growth opportunities – or ride out any drop in sales – without diverting funds from other critical priorities. Whilst all financing decisions carry risk, SMEs can give themselves the best possible chance of success, and expansion, by aligning with SMEs strategy and not exceeding the SMEs risk tolerance level when taking on bank loans.
