Commercial Loans

Commercial loans are short-term loans used to raise a company's working capital and meet heavy expenses and operational costs. It is a kind of financing often used by small companies that cannot afford to raise money from equity markets and bonds.

Banks and well-established financial institutions often provide commercial loans against the debtor's financial statements and credit score. They are financial products that are specially designed for funding daily business operations and meeting short-term expenses.  

• Commercial loans boost a company’s working capital and fulfill heavy expenses and operational costs. 
• It is a finance type often small companies use that cannot manage to raise money from equity markets and bonds. 
• Banks, credit unions, and well-established financial institutions typically offer commercial loans against the debtor’s credit score and financial statements.
• Commercial loans include term loans, bank overdraft facilities, letters of credit, and leasing. Each loan type has repayment terms, interest rates, and collateral requirements. 

Commercial loans are the type of loans that are given to companies who need them to fund the short term business operations, working capital needs, expansion or daily expenses. They are provided by banks or financial institutions.

The process of availing of the loan, guarantee from banks, and Letter of Credit is often time-consuming and has higher documentation costs. Some sources, such as bank overdraft facilities, require minimal documentation and are less time-consuming. That streamlines the prospect of fundraising as per the company's requirements.

It is crucial to think about a strategic partner for advice on various business operations, markets, etc. In that case, then VC or PE is a better choice. However, if there is need of money, commercial loans are the way forward.

When the borrower default on repayment, their credit rating reduces. Its adverse effect would be felt when they go for the next round of finance as the loan terms would change.

A company that frequently borrows may only reap a few benefits for its shareholders. From a monetary aspect, EPS reduces. In recent years, many companies have gone bankrupt because of their inability to pay their debt. Therefore, the appraisal of the entity in commercial loan process is essential.

The various basis of its classifications is repayment term/time, lending authority, loan amount, etc. Let us begin with the simplest version.

#1 - Term Loans

It is the most basic loan that banks lend to business owners. And as the name suggests, it has a fixed repayment term, commercial loan rates, and maturity date. Usually, term loans with collateral carry lower interest points than those without collateral. It is because the risk without collateral is more for the bank. The classification based on the term is as follows: -

#2 - Bank Overdraft Facility

Consider this. Betty needs to pay $150,000 immediately to her supplier. However, the customer has promised to pay $180,000 after three days, and she has only $10,000 in her bank account. So, the best course would be to go to her banker and avail a bank overdraft facility for a $20,000 deficit. The biggest benefits of bank overdrafts include lower commercial loans rates than term loans and the least documentation.

#3 - Letter of Credit

A letter of credit is a document issued by the bank to the supplier that guarantees payment based on which he will supply goods to the purchaser. It is widely used in import-export transactions whereby the parties do not know each other.

#4 - Leasing

Leasing is a financing medium that allows companies or individuals to own specific assets for interim payments for a particular period. In normal circumstances, the asset reverts to the lessor at the end of the lease unless mentioned in the agreement.

A cosmetics manufacturing company Beauty & Care Ltd wants to diversify its product range for which it needs to purchase raw materials and machinery worth $100,000. The company wants to apply for commercial loan from a ABC Bank.

Beauty & Care Ltd visits ABC Bank with its business plan, completes the loan application, and also submits the required documents that include financial statements, list of assets, business plan, tax returns, and some other relevant documents required by ABC Bank.

The bank evaluates the creditworthiness, does the SWOT Analysis, checks the background of the business owners and then approves the loan of $100,000 with an interest rate of 6% payable within 6 years.

Thus, the agreement is signed between the two parties, and the loan amount is disbursed to the business account of Beauty & Care Ltd, completing the process. Here we see how the company qualifies for the amount and gets the funding.

In order to qualify for commercial loan process it is important for the business to have a good brand image, be financially strong and stable and also have good credit rating. However, some points to remember for the above are as follows:

• Have a good business plan – A well designed business plan which clearly states the vision, mission, financial analysis, market positioning, future growth prospects, etc will be able to qualify for loan easily.
• Good brand image – If the products and services of the company are in demand in the market, and they are of good quality and useful, have a huge customer base, that means the brand name is good. This will help in getting the loan since it ensures high sales and creditworthiness.
• Good credit rating – The credit rating should be good, which means the business should have the ability to pay back the loan.
• Transparent financial reports – The income statement, balance sheet, cash flow statement, should present a true and fair view of the business.
• Enough assets for collateral – The company should have enough assets to be used as collateral against the secured commercial loans. This will ensure good payment terms and low interest rates.
• Owner’s business skills- The lenders always assess the expertise, skill and experience of the borrower because it ensures that the future of the business is in good hands and it will grow and expand in the coming years.

However, criterias vary depending on type of business and requirements, but it is necessary to have all documents and records in place and maintain a good name in the market in order to qualify for such loans.

The above are two different types of loans used for two different purposes. Let us look at their differences.

• The former is for meeting the financial requirements of a business whereas the latter is for financing the purchase of residential properties.
• The commercial loan structure is granted after assessing the financial stability of the business whereas the latter is granted after assessing the financial condition, income and assets of the individual.
• The tenure of secured commercial loans are usually from a few months to 10 years, whereas the tenure of residential loans are usually 15 to 30 years.
• The interest rates of the commercial loan structure is more than the latter due to their higher risk.
• The loan size of the former is larger than the latter because it is for business requirements.
• The documents for commercial loans are more in details and extensive as compared to residential loans.

This article is a guide to what are Commercial Loans. We explain its types along with example, how to qualify and the differences with residential loans. You can learn more about it from the following articles: -

• Commercial Credit Definition
• Commercial Bank Definition
• Top 5 Careers in Commercial Banking
• Ninja Loans
• Working Capital Loan