Bank loans have been one of the most traditional ways for companies to get access to capital. This article explains how bank loan works and explores its pros and cons, covering the following topics:
- What are bank loans?
- How do bank loans work?
- Advantages of bank loans
- Disadvantages of bank loans
- Alternative to bank loans: revenue-based financing
- Some last words
What are bank loans?
Bank loans are term loans provided by bank lenders for your business to meet your financial needs. Interests will be charged on outstanding balances, and you need to make repayments according to a fixed schedule.
To apply for a bank loan, you are usually required to provide property or equipment as collateral. In the event of default, these assets will be seized and sold by the lender to recoup its loss.
How do bank loans work?
An application for commercial loan typically begins with submission of application forms, along with documents such as your company’s certificate of incorporation and financial statements.
Upon collection of all required documents, the bank performs credit analysis on your business, taking into account a number of factors to determine whether a loan should be granted.
These include your company’s financial statements, cash flow, business plan and asset coverage ratio, but to name a few.
If your loan application is successful, the bank will provide you with cash, which is to be repaid at a certain interest rate.
Normally, you will also need to provide tangible assets as collateral. In the event of default, these assets will be seized and sold by the bank to recover the debt amount.
No doubt, banks have played a major role in financing traditional businesses.
Nevertheless, bank loans may not be suitable for newer, innovative and fast-growing e-commerce companies. This is because these companies tend to have fewer pledgeable assets and higher risk-return profiles.
With these unique features, these companies may find it difficult to qualify for loans under the conventional credit assessment model used by bank lenders. Lack of standard financial statements could also be a hurdle to obtaining bank loans.
Advantages of bank loans (Pros)
Disadvantages of bank loans (Cons)
Disadvantages
Complicated application procedures
Long turnaround time
Collateral required
Difficult to qualify
Rigid repayment schedule
Interests on outstanding balance
Restrictive covenants
Explanation
Bank loan applications require collection and submission of lots of paperwork. The process could be taxing and time-consuming.
The loan approval process could take months.
- E-commerce companies may not have adequate tangible assets to serve as collateral.
- In these circumstances, banks may require that the loan be secured against your personal assets
- Some bank lenders require that businesses be established for a certain period of time (e.g. 2 years or even more) in order to be an eligible applicant.
- Credit assessments are not easy to pass
- Repayments must be made on schedule.
- Loan default could lead to seizure of collateral. It would also affect your credit score, making it harder for you to borrow from financial institutions in the future.
Interests accrue on unpaid amounts. Cost of debt could be high if you fall behind on loan repayments.
There may be restrictions on how you use the borrowed money.
Alternative to bank loans: revenue-based financing
Revenue-based financing (RBF) has gained popularity among small and medium businesses, startups, e-commerce companies in recent years.
In essence, revenue-based financing is an alternative financing method in which companies receive funding based on future revenue.
After putting in an application for revenue-based financing, risk assessments will be conducted on your business.
If you are eligible for funding, capital will be remitted in as soon as 48 hours.
Contrasted with borrowing from banks and repaying fixed amounts regularly, revenue-based financing gives you ample flexibility in repayment.
Under the RBF approach, RBF platforms (which provide funding) will share a small percentage of your monthly revenue as repayment for the capital provided.
If you have a slow month, you pay back less; if business is good, you pay back more.
Ultimately, repayment is capped at a predetermined amount, which is usually the capital plus a small flat fee.
Pros and cons of revenue-based financing
Should you consider bank loans or revenue-based financing?
Just like each individual is unique, no two companies are the same.
There is no such thing as the best financing option for businesses, only a financing option that best serves your business needs.
To help you find the right fit for your business, Choco Up has compiled a table comparing bank loans and revenue-based financing.
Source: choco-up.com