Debt financing is money loaned to you or your business, for which the lender has a right to earn interest. Institutions, usually commercial banks and credit unions, lend a portion of the value of your business’ fixed assets. You can use this financing to buy inventory or additional fixed assets, or to help your business through a cash shortfall.
Today, let’s look at using term loans to finance your small business’ needs.
What is a term loan?
With a term loan, you will be lent money on a short-term (months to two years) or long-term (two to 10 years) basis.
The terms and conditions for repayment of a term loan, including the finance charge or interest rate, are specified in the loan agreement. A loan may be payable on demand (a demand loan), in equal monthly instalments (an instalment loan), or it may be good until further notice or due at maturity (a time loan).
The term of the loan should depend on the useful life, in years, of the assets that the loan is secured with. Term loans are usually used to finance equipment, where the term of the loan is matched to the useful life of the asset.
For example, you shouldn’t agree to a six-month term loan for a piece of equipment that’s expected to last for 10 years. Instead, tie the loan payment term to the expected life of cash inflows from your equipment, and then take your time repaying the loan.
This is synchronizing cash inflows and loan payment terms if cash is tight — and it usually is when you’re first starting your business.
Remember that cash mismanagement is a common cause of small business failure. Be sharp when you’re negotiating your term loan!