How Do Business Loans Work?

There are many reasons that a business may need to raise extra capital. Usually, these extra funds are used as an investment to expand and grow the business to increase profits.

The issue for many businesses is that there is a seemingly endless amount of options available when it comes to business finance. In this guide, we’ll talk you through how each one works and help you decide which type of business loan will best suit your situation.

What is a business loan?

A business loan is just that, a loan specifically designed for businesses. Typically, a person or individual would not be eligible for one as the terms and conditions are quite different from those that come with personal loans.

Crucially, with a business loan, you can borrow anywhere between £1,000 and £3 million, depending on the size of your business. Repayment periods are between 3 months and 5 years.

Before proceeding with a business loan, it’s helpful to understand some essential loan-related terms. These include:

• Principal: The original amount of money borrowed before interest is added.
• Collateral: Assets that a business may pledge to secure a loan. If the loan is not repaid, the lender can seize these assets.
• Interest Rates: The percentage charged by the lender for borrowing money. Interest can be either fixed (stays the same over the loan term) or variable (changes based on market conditions).
• Repayment Term: The length of time over which the loan must be repaid. This can range from a few months to several years, depending on the loan type.
• Term Loan: A standard business loan where you receive a lump sum upfront and repay it over a set period, often with regular monthly payments.

Despite there being many different types of business loans, ultimately they fall into two separate categories; secured and unsecured business loans:

Secured business loans

Secured loans allow your business to borrow money against assets. This means that if the loan repayments are not met, your assets can be seized and used as repayment.

Unsecured business loans

Unlike secured loans, an unsecured loan lets you borrow money without having to secure it against any company assets.

Business assets are anything that your company owns outright which are used for business purposes. These could be almost anything but some of the most common examples are stock, machinery and property. All of these can be used as collateral to secure a loan if needed. If this is the case then a representative from the finance company will be able to value your assets before approving your loan.

What can you use business loans for?

Business loans are great in that you typically do not have to specify what the fund will be used for. Some of the most common uses for new business finance include:

• Acquiring new stock
• Hiring more staff
• Moving location 
• Expanding current premises 
• Upgrading current or buying new equipment and machinery
• Paying off existing debts 

Business loans provide a great way in which companies can expand when the need arises but also offer the ability to stabilise operations due to unforeseen circumstances.

What types of businesses can get loans?  

Almost all businesses can access business finance in one way or another. Many financial products are available, each with a very specific set of criteria aimed at different business sizes. 

Cash loans come with minimum trading requirements and require applicants to demonstrate that they have been trading for a certain length of time.

There is also no limit to the number of loans that a business has. They must, however, be able to demonstrate the ability to pay each one back.

Business loan eligibility and qualification requirements

Before applying for a business loan, it’s essential to understand the eligibility criteria that most lenders require. These criteria can vary depending on the type of loan, but common requirements typically include:

• Credit Score: Lenders will check your business credit score to evaluate the risk of lending to your business. A good credit score demonstrates reliability in repaying debt.
• Business History: Many lenders prefer businesses with a minimum amount of operational history (often around three years). Newer businesses may find it more difficult to secure loans.
• Annual Revenue: Lenders often have minimum revenue requirements to ensure the business has sufficient cash flow to repay the loan.
• Personal Guarantee: For unsecured loans, lenders may ask for a personal guarantee from business owners or directors, making them personally liable for the debt.

It’s important to prepare your financial documents, such as tax returns, profit and loss statements and a business plan, to present a comprehensive picture of your business’s financial health. For further information, read our full article on business loan requirements.

Risks of taking a business loan

While business loans can be a powerful tool for growth, they come with risks. It’s essential to understand the due diligence process and the potential consequences of not being able to repay the loan:

• Risk of Default: If a business is unable to repay the loan, the lender can take legal action or seize assets that were pledged as collateral. This can negatively affect the business’s operations and reputation.
• Interest and Fees: Business loans often come with interest and fees that can add up over time. It’s crucial to understand the total cost of the loan, not just the amount you borrow.
• Impact on Cash Flow: Taking on a loan can affect your cash flow due to regular repayments. Be sure that your business can handle the repayments without straining daily operations.
• Personal Liability: For some loans, business owners may be required to provide a personal guarantee, meaning they are personally responsible for repayment if the business fails to do so.

The due diligence process involves careful evaluation of your business’s financial health, your ability to repay, and the specific terms of the loan.

The different types of business loan

As we have mentioned, there are many different types of business loans available. Depending on the size of your business and the sector in which you operate, you may have access to some or all of the following:

Short term loans

Lasting anywhere between 3 months to 12 months, a short term loan is ideal for when immediate problems or opportunities come up that need tackling.. The issue with this sort of loan is that lenders tend to charge higher interest rates that are applied on a monthly basis, as opposed to an annual one. 

Government start-up loans 

These are loans provided by the government that help new businesses get off the ground. They combine a mixture of low-interest rate loans and grants with businesses able to borrow up to £25,000 over a five year period.

Bank loans

These are one of the most common types of loan. Finance provided by banks and building societies allows your business to borrow a lump sum and pay it back over an agreed period.

Most of these business bank loans need a director’s guarantee. This means that if a company cannot pay the loan back, the director will be personally liable.

Asset finance

Asset finance is a useful tool that allows businesses to secure finance against their assets. This usually allows companies to borrow more than they would be able to with a typical loan as the total value is secured against said assets.

Almost any kind of asset can be used as collateral but the most common are machinery, property, land and stock.

Invoice finance

Invoice financing is a perfect product for any business that has multiple outstanding invoices yet to be paid. A lender then buys these invoices from you (for a fee), allowing you to raise the outstanding funds immediately. 

There are two types of invoice finance:

• Factoring – This is where the lender manages the invoices themselves, processing sales and collecting the outstanding invoices.
• Invoice Discounting – This is where the funds are released before any invoices are paid. You then owe the lender any outstanding balance.

Business development loans

Business development loans are for just that, developing and expanding current business operations. Whilst these are often offered by banks and building societies, it is recommended to use specialist financing companies where a detailed plan and flexible arrangement can be drawn up.

Some of the things business development loans can help with include:

• Projects and growth initiatives 
• Business acquisitions
• Partner buy-ins & buyouts 
• Research and development
• Renovations and refurbishments 
• Stock purchasing

White Oak UK is an FCA authorised and regulated lender that operates across Europe. We have over 25 years of experience in helping businesses to raise finance in a way that suits them and their setup. 

We offer a wide range of finance package options that can help both established businesses and those just starting out. Get in touch with our expert team of finance advisors today.