Access to capital is a fundamental feature of healthy business operations. Small businesses, in particular, rely on various forms of commercial financing to make ends meet. Growth investment, real estate, payroll and start-up costs are only a few of the expenses customarily covered by business loans. In practice, many businesses require loans just to cover gaps in the cash flow cycle.
Although outside funding alternatives secured for commercial purposes bear similarities to personal financing, there are noted differences in the way small companies and sole proprietors acquire funding. Whether seeking secured financing for real estate purchases, or revolving credit terms to cover various operating costs, commercial borrowers must account for unique concerns associated with business lending.
Without a long track record to study, it can be difficult for small businesses owners to project working capital needs. In fact, even well-established companies struggle with the concept, at times, due to the ebb and flow of business resources. In order for an organization to glean actionable information about working capital, it pays to understand the principle, in terms of its operating cycle.
Operating cycle captures working capital needs based on the number of days required to carry-off business functions. The length of time it takes turn-over inventory or convert it to a receivable, for example, represents one component of the cycle. Accounts payable, measured by the number of days it takes an organization to settle an invoice, is another key feature of the cycle. Receivables, or the period that typically elapsed between submitting invoices and receiving payment, accounts for the essential third leg of the operating cycle.
With operating cycle in mind, businesses overcome short-term financing needs using a number of funding alternatives. For some, with well-established accounts, terms can be extended by creditors, giving them more time to come-up with money to pay for orders. Net 30-day terms, for instance, can be temporarily extended to net 60, and so on. Others, with less sway among industry creditors, use short-term loans to ensure the operating cycle flows smoothly. Though typically extended for a year or less, the loans adequately bridge cash flow shortfalls, covering inventory spikes and other near-term needs. Equity resources and lines of credit provide additional funding avenues, though these alternatives almost always require personal guarantees.
Factoring is another unique cash flow option available to businesses. The process uses money owed to an organization as a form of collateral. In order to access needed capital using factoring, a participating business sells receivables to an intermediary known as a factor. Factors first check creditworthiness and other aspects of the businesses involved (both ends of the transaction), before agreeing to buy outstanding receivables debt and advance a certain portion of the sum to the business needing immediate financial resources. The move provides faster cash than waiting for payment, making the difference during cash flow slowdowns. Once paid, the remaining balance passes through to the issuing partner, less a factoring fee, paid for the privilege.
Private lenders maintain their own standards, but regardless of the loan originator, similar requirements apply for those seeking business financing. For starters, loans are only granted to those funding legitimate business enterprises. Gambling operations, speculative investments and other passive schemes, for example, do not pass muster among lenders. Principals of an organization must also present in good standing, with positive credit histories, sound character, and experience running businesses.
Most business loans require collateral, which can be drawn from personal and commercial assets. And to be approved, borrowers must have a personal stake invested in the business, beyond desired financing. For the best chance of receiving approval, expect to provide the following:
These are starting points for most lenders, which may require deeper documentation and personal guaranties from each applicant.
Small business funding is initiated by various financial organizations, including banks and credit unions. For the best results locking-in cash, target pre-existing relationships, tapping bankers with whom you have history. Small, community institutions are more likely to approve loans for regional businesses, when compared to major, national lenders.
Conducting preliminary research and preparation also increases the chance of securing needed funds. In addition to business plans, understanding your business cycle adds legitimacy to loan requests. Clearly defined financing needs also keep the process moving, assuring bankers you've done your homework. Median lending levels among private banks fall between $100,000 – $150,000 for each approved business applicant, but your request should not exceed needs outlined during the review process.
Like primary residences, buying investment properties and those used for business functions typically requires major financing. And while property loans bear similarities, regardless of how they are applied, commercial borrowers face unique concerns preparing for a purchase.
Down Payment – Mortgage requirements vary among lenders, but they are heavily influenced by underwriter mandates. Primary residences, for example, can generally be financed with down payments between five and ten percent of the value of a loan. For lending entities, funding owner-occupied properties is less risky than other forms of financing, so terms favor applicants.
Financing investment properties and funding commercial endeavors, on the other hand, exposes lenders to greater risk, so applicants should expect to furnish higher down payments for investment and commercial properties. Typically, an investment property mortgage calls for a minimum 20% down payment – for well-qualified applicants. Though down payments in this range push many deals forward, acquiring multi-unit buildings and those intended for commercial use often entails more substantial deposits.
Type of Property – Residential real estate is commonly defined as a single-family home or multi-family property with four or fewer units. Beyond this narrow identification, other forms of real estate are considered commercial in nature. That means retail, office, warehouse, industrial and even many vacant land parcels fall into this category. Beyond the general classifications of commercial vs. residential, individual property categories are broken-down further, designated as income producing or non-income producing, for example. In the eyes of financial institutions issuing loans, each property-type is viewed as a specialized niche, calling for a particular form of funding.
Lenders evaluate commercial property in terms of the cash flow attached to each parcel. A free-standing big-box building, for instance, has very different financial characteristics than a strip mall or a grocery outlet, so lenders do not lump them similarly – despite the fact that they are all utilized for retail trade. In fact, lenders prefer to loan money to lessors, rather than funding business-owner tenants, occupying the commercial spaces. Whether owner-occupied or simply sought for investment purposes, specialized property types receive unique consideration from lenders, including these dedicated uses:
Individuals vs. Commercial Entities – Residential mortgages are typically issued to individuals, leaning on clear chains of responsibility and detailed personal credit histories. Commercial funding needs, on the other hand, most-often originate from partnerships, corporations, and other entities formed for commercial purposes. In either case, the loans are guaranteed by the value of real property, but businesses seeking mortgages often lack extended credit histories similar to those attached to individual, residential mortgage applicants. As a result, commercial lenders frequently mandate personal loan guarantees from their clients.
Repayment Expectations – Residential mortgages are commonly issued with 30-year payback periods. Qualified borrowers can accelerate repayment, choosing 15-year mortgages or other terms approved by lenders. Once contracted, an amortized individual mortgage repayment schedule is made available, outlining the entire decades-long repayment protocol. Payments are made in regular amounts, typically on a monthly remittance program. In contrast, commercial loans carry shorter payback periods and often include balloon payments.
Business loans generally require payback within five to twenty years. In many cases, disbursed funds are approved for an initial payment period, then wrapped-up with a final balloon payment, representing a substantial portion of the loan's total value. Interest rates vary, depending upon the size and scope of a loan and the strength of applicants' credit.
The amount of equity held in a property also influences terms and conditions. This holds true for residential and commercial funding, but business borrowers are particularly susceptible to lender scrutiny, in this area. Loan-to-value (LTV) is a fundamental concept applied to commercial loans, which accounts for the relationship between appraised value and the requested sum. Generally, borrowers with substantial equity and lower LTV have access to the lowest interest rates and enjoy the fastest track to approval.
Debt Service Coverage Ratio – In order to limit risk and ensure repayment, lenders analyze each investment property's inherent ability to pay for itself. Debt Service Coverage Ratio (DSCR) looks at principal and interest payment obligations, relative to the amount of cash flow a particular property is anticipated to generate. To calculate the ratio, Net Operating Income (NOI) is divided by a property's annual mortgage debt service. Ratios indicating negative cash flow are risky propositions for lenders and investors, so funding entities look for a positive ratio of at least 1.25. Specialty properties, with particularly volatile cash flow conditions – like hotels and short-term housing, are held to a higher standard, because long-term leases are not in-place to cover mortgage payments.
Prepayment Penalties – While most residential mortgages do not carry prepayment penalties, commercial funding often protects a lending agency's ability to make money. In practice, this means cash penalties may be imposed against commercial borrowers that choose to accelerate repayment. Lockout periods are also written-in to business contracts, ensuring a bank's right to collect interest for a predetermined period. When imposed, lockouts typically cover an initial term, during which a borrower is prohibited from paying-off the debt. Similarly, interest guarantees protect lenders' income, fixing the amounts paid on each loan, irrespective of the borrower's repayment plans.
Peer-to-peer platforms have gained ground in recent years, establishing direct relationships between private parties needing cash, and those with available resources. The paradigm has shifted considerably, when compared to the grass-roots principles initially governing peer-to-peer prospects. In practice, today's crowdfunding options are more similar to traditional institutional financing than ever before, reflecting an emerging class of funding entities, operating within the industry.
Businesses needing capital benefit from popular lending platforms like Lending Club, Upstart and Prosper. The alternatives augment traditional financial institutions, offering competitive interest rates and favorable terms for borrowers. Applicants with credit scores in the mid-600's may be eligible for small loans, which can be used for business functions.
Credit cards furnish immediate access to capital for approved cardholders. Flexible, revolving terms make them ideal for some commercial applications, including short-term inventory requirements and other funding needs. Credit lines vary, depending upon strength of credit and other factors, but well-established businesses often enjoy liberal limits.
Credit cards are administered on a revolving basis, without collateral, so there is substantial risk for companies issuing lines of credit. As a result, credit card interest rates are comparatively high. For users filling cash flow gaps and relying on cards for near-term expenses, paying a few extra interest points is manageable – a cost of doing business. On the contrary, operators in need of substantial, long-term resources are not well-served by high interest credit cards.
Various funding alternatives help small businesses grow and operate in competitive environments. Commercial loans fund startup capital requests, inventory needs, real estate, operating costs and countless other business expenses. In most cases, borrowers navigating the commercial lending industry secure the best interest rates and terms when their applications include strong credit references and personal guarantees. Using a tool like this one can help borrowers compare the cost of various financing options.