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Bank Loans – Advantages and Disadvantages for SMEs

bank loan advantages and disadvantages

Whether funds are required to set the foundations for a start-up business, continue to operate or even grow a business, the most common method of funding for small and medium-sized organisations (SME) is bank loans. Businesses will need to evaluate the strengths and weaknesses of this type of funding 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.

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. 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.

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.

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 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.

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 length of time 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 on an organisation other than just a poor credit rating.

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.

Key Risks of Bank Loans SMEs Should Consider

Below are some key risks that each SME should consider before deciding to secure financing using loans:

Burden of Debt

A debt burden places the entire business at risk and each SME must consider if loan repayments will remain manageable before agreeing to the loan. Loan repayments are non-negotiable..

Loss of Collateral

Any missed repayments could result in the bank taking control of assets impacting future growth. All options should be explored to determine whether risk is acceptable before deciding to secure company assets against any bank loan.

Rising Interest Rates

As well as affordability, SMEs with variable rate loans should consider how any unexpected increase in loan repayments would be managed.

Cash Flow Disruption

To limit impact on cash flow, SMEs should plan and monitor loan repayments carefully and be able to act quickly if there’s any deviation due to interest rate increases or defaulted payments.

Damaged Credit Rating

SMEs must monitor loan repayments to avoid any defaults which impact credit score and have an adverse effect on future applications while remaining on an SMEs record for years.

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.

Other Financing Options for SMEs to Consider

There are alternative funding options available to an SME other than bank loans:

Equity Investors

A good method to avoid increasing debt is to look for investment from sources such as venture capitalists or private equity firms. This would mean sacrificing a stake in the business but may be a more attractive option than bank loans.

Peer-to-Peer Lending

Borrowing from other investors can be quicker and give the SME the boost it needs at just the right time. This is usually more flexible than traditional banks and can be sourced on platforms such as Funding Circle.

Invoice Factoring

Selling outstanding invoices for a percentage of the outstanding amount to factoring agencies can be a good way to recover proceeds for products or services which have not, or are not, likely to be paid for.

Supply Chain Financing

Taking out finance with suppliers instead of banks can be beneficial to cash flow timing although repayment rates will be higher as suppliers are aware of your need for quick finance.

Grants and Loans

SMEs can receive better rates when applying for loans through government grants or other start-up funding initiatives, although opportunities are limited.

Crowdfunding

Crowdfunding is when several different small independent investors combine proceeds and invest a consolidated amount in the company as one larger investment.

Conclusion: Key Considerations for SMEs Exploring Bank Loans

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. .

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