The Good And Bad About Business Loan Financing
Jun 16, 2023
Business loan financing—also known as external financing—is when small businesses borrow money from an outside source to operate. A repayment schedule and interest rates are established at the start of the loan, for which the business owner is accountable to pay. Business loan financing comes in handy under some circumstances;
Fast-growing businesses: Loan financing may be ideal when high-growth companies need expanding amounts of capital. Plus, an increasing cash flow is necessary to make this loan viable, as well as to make interest payments.
Short-term financing needs: Loan financing can provide short-term financing needs such as the business’s investments in accounts receivable and inventory. The loan usually matures in less than a year.
THE GOOD ABOUT LOAN FINANCING
Tax deductibility: The interest payments made on the loan are considered expenses which are tax-deductible. For instance, if the company’s marginal tax rate is 30%, the amount of the interest payments shields that amount of income.
Management control: Business owners are only obligated to make payments on time. Otherwise, they retain their rights to operate their business however they wish, without outside interference from investors.
Lower interest rate: Due to the interest payments being tax-deductible, the interest rate business owners get on loan financing will be much lesser.
Business credit score: Loan financing can improve the business’s credit score by showing how well it can handle its debt—such as by making timely payments.
No profit sharing: Since there are no investors involved in loan financing, business owners do not need to share their profit with creditors. They also get to distribute it when needed.
THE BAD ABOUT LOAN FINANCING
Repayment: Regardless of the business’s cash flow, it has to make payments on the principal and interest—even if it shuts down or forced into bankruptcy. The lenders will also have a repayment claim.
Cash flow: High reliance on loan financing will result in a lower cash flow since principal and interest payments have to be made. Negative cash flow can put small businesses at stake.
Collateral: Small business owners may have to put up their private assets—such as their homes—for collateral to get loan financing.
Credit rating: Too many loans registered on the business’s credit report will affect its credit rating. So, the more it borrows, the higher the risk is on the lender’s end—which will cause a higher interest rate reflected on each subsequent loan.