What is a business loan?

A business loan is a debt-based financing arrangement between a business and a financial institution such as a bank. It is generally used to finance large capital expenditure and / or cover operational costs that the business might otherwise not be able to pay. High upfront costs and regulatory hurdles often prevent small businesses from gaining direct access to bond and stock markets for funding. This means that, just like individual consumers, small businesses must resort to other loan products, such as Credit lines, unsecured loans or term loans.

How Business Loans Work

Commercial loans are made to various business entities, usually to meet short-term financing needs of operational costs or for the purchase of equipment to facilitate the operating process. In some cases, the loan can be extended to help the business meet more basic operational needs, such as financing payroll or purchasing supplies used in the production and manufacturing process.

These loans often require a business to post collateral, usually in the form of tangible fixed assets that the bank can confiscate from the borrower in the event of a default or bankruptcy. Sometimes the cash flow generated by the future accounts receivable are used as collateral for a loan. Commercial real estate mortgages are a form of commercial loan.

Special considerations

As is the case with almost all types of loans, the solvency an applicant plays a leading role when a financial institution is considering granting a business loan. In most cases, the business applying for the loan will need to present documents, usually in the form of balance sheets and other similar documents, proving that the business has favorable and consistent cash flow. This assures the lender that the loan can and will be repaid on its terms.

If a business is approved for a business loan, it can expect to pay an interest rate that matches the prime rate when the loan is issued. Banks generally require a financial state of the business over the life of the loan and often require the business to carry insurance on any larger items purchased with the loan funds.

Types of business loans

While a business loan is most often seen as a source of short-term funds for a business, some banks or other financial institutions offer revolving loans that can be extended indefinitely. This allows the business to get the funds it needs to keep its business going and to pay off the first loan on time.

After that, the loan can be turned into an additional loan period or “roll over”. A business will often look for a revolving business loan when it needs to secure the resources it needs to handle large seasonal orders from certain customers while being able to supply merchandise to other customers.