Commercial Loans Definition
Commercial Loans is the amount raised as borrowings either from a local banker or foreign banks or others usually by a company for its working capital, operational use and at times for capital expansion with a view to benefiting the stakeholders, such that it increases the economies of scale or reduce the cost to the company. The banks usually park funds from their corpus for this purpose.
Types of Commercial Loans
Few commonly used types of commercial loans either obtained locally or abroad are:
#1 – Term Loans
Have you ever walked to your banker for your company to get a loan? Yes, that is the term loan. Usually, term loans with collateral carry lower interest points than the once without collateral, majorly because the risk for the bank for loans without collateral is more. Classification based on the term is as follows:
#2 – Bank Overdraft Facility
Consider this, Betty needs to pay $150,000 immediately to his supplier, his customer has promised to pay him $180,000 after 3 days. He has only $10,000 in his bank account. What does he do? The best course would be to go to his Banker and avail and Bank Overdraft facility for a $20,000 deficit. The Benefit of this source is the interest rate charged is less than term loans and guess what, usually no or minimal documentation (Saves a lot of time!!)
#3 – Letter of Credit
A letter of credit is a document issued by the bank to your supplier that guarantees him payment based on which he will supply good to you. This is widely used on import-export transactions whereby the parties do not know each other.
#4 – Leasing
A transaction in which the parties enter into an agreement, whereby one agrees to give the asset (Lessor) for another to use (lessee) in exchange for periodic consideration. The asset reverts back to the lessor at the end of the lease in normal circumstances unless explicitly provided in the agreement. This is used when the lessee does not have enough funds to purchase the asset or when he need it temporarily.
Advantages of Commercial Loans
- It does not dilute your shareholding. when you raise funds from a bank, does your bank ask for a share in profits? No, right!. Had you asked for the same money from a person by way of investment (Venture capitalist (VC), Private equity (PE), etc.) they would ask for a share and may also get right in participation in your company’s affairs? So the source keeps your shareholding safe.
- Imagine, an asset Is required which your company cannot afford, what will do? Lease it. Use it till you want and return it back. Hence reduces your capital expenditure. The source of funds otherwise available can be used for other productive purposes.
- In case a person wants to pay off the loan before maturity date he can pre-close it and save interest. If he is unable to pay on time, seek the banker for the extension. It offers a great amount of flexibility.
- Interest paid on loans is charged against profit but the dividend is not. Which means that payment of interest is more viable in terms of Income tax-related deductions than the dividend. For better understanding refer below.
Disadvantages of Commercial Loans
In spite of the advantages, it does come with some disadvantages.
- Unsecured loans are given by the banks based on past trends in terms of repayments, cashflows and credit rating of the company. Hence not easily accessible to startups and small companies.
- Sometimes the bank extends funds based on certain conditions, such as minimum stock to be maintained by the company, the profits to be earned during quarters and at times would even have representatives in the board of directors. This may raise eyebrows as the normal business operation are subject to various conditions.
- The effective price paid at the end of the lease term is higher than the cost of the asset. For example say you lease an oil filtering machine for $1,000,000 per annum for 8 years. The cost of the asset in the open market is $6,000,000.
Points to Consider
- The process of availing the loan, Guarantee from banks, Letter of credit is often time-consuming and attached with it are documentation cost. While some sources such as bank overdraft facilities require no or minimal documentation and less time-consuming. Hence these have to be factored in when deciding the source of finance.
- The interest coverage ratio (ICR) in proportion to the earnings before interest and tax (EBIT) or earnings before interest, tax, depreciation, and amortization (EBITDA) to the interest paid. As the interest outflow increases the ratio reduces. This creates a pessimistic mindset on the existing loaners.
- When considering to raise funds one important point to think about is whether you need a strategic partner to advise you on various business operations, markets, etc. In case you do then VC or PE is a better choice. If you just need money, then commercial loans are the way forward.
- When you default in payment of dues to the other parties your credit rating reduces, this impact would be felt adversely when you go for the next round of finance as the terms of the loan would change.
- A company that frequently borrows may not reap many benefits to its shareholders. In terms of monetary aspect, EPS reduces. Not monetarily it creates an impact that the business is run from the outsider’s funds and not theirs, involvement in business may reduce.
- In the recent past, many companies are going bankrupt! The reason being they are unable to pay the debt that they have raised. The appraisal of the entity in this aspect is essential.
Commercial loans have proved to be an effective source of finance but require a detailed analysis of the following:
- The decision on the type of commercial loan must be based on the business need
- Additional funds required should be based on the comparison between the required and the existing fund and the time period for which it is required.
- The cost involved in raising funds in terms of interest cost, lease rental payments and initial documentation costs in obtaining finance should be compared with its benefits expected so that decision benefits the stakeholders.
This has been a guide to What is Commercial Loans and its Definition. Here we discuss the commercial loan types along with advantages and disadvantages. You can learn more about from the following articles –