Chapter 3: Understanding Loan Structures: Picking the right fit for your business
Introduction
Picking the right loan structure can make or break a business. Whether your business is in growth mode, stable, or navigating challenges, selecting the correct finance product is crucial. The industry you operate in and its unique requirements also play a vital role in shaping the right funding strategy.
Far too often, I’ve seen loan facilities structured to treat a business’s symptom (e.g., cashflow shortages) rather than addressing the root cause. In banking, this distinction is known as the borrowing cause vs. borrowing need.
This month’s article breaks down common commercial loan structures and how to choose the best fit, not just for today, but for your business’s long-term success.
1. The Importance of Choosing the Right Loan Structure
When applying for commercial loan facilities, the first step is identifying the root cause of the funding need.
Borrowing Cause vs. Borrowing Need Example:
A transport company experiencing cashflow shortages due to delayed payments from corporate clients (borrowing cause) may believe it needs a lump sum loan (borrowing need). However, the better solution might be an invoice financing facility, which provides ongoing liquidity by unlocking funds tied up in unpaid invoices.
For instance, if a business is struggling to cover overheads (such as wages or rent), borrowing a lump sum might seem like the easiest solution. However, a deeper analysis might reveal that the issue isn’t a lack of capital but a liquidity mismatch, where payments from clients are received later than expenses are due.
In this case, the right solution may be an overdraft or invoice financing rather than term debt. Conversely, if the business owes tax arrears, a term loan might be the better option rather than an overdraft, which could become a long-term burden.
The right loan structure must align with your business’s future position and not just its current situation. As I discussed in last month’s article, cashflow forecasting is key to ensuring your financing decisions support sustainable growth.
2. Overview of Common Commercial Loan Structures
a) Term Debts
Term loans provide businesses with a lump sum upfront, typically for specific purposes such as mergers & acquisitions, refinancing, tax debt repayment, or restructuring. These loans are usually repaid in either of the following ways:
Principal & Interest Loans: Best for businesses wanting to steadily pay down debt over time. Depending on the lender and loan size, these loans can be structured over 15 to 30 years.
Interest-Only Loans: Suitable for businesses that need lower initial repayments, particularly during expansion phases.
Borrowing Cause vs. Borrowing Need Example:
A manufacturing company might see a need to take out a large term loan to expand production capacity (borrowing need). However, if the true cause of their financial strain is seasonal fluctuations in demand (borrowing cause), a revolving line of credit may be a more suitable solution.
b) Fixed vs. Variable Rate Loans
Interest rate risk is a key consideration for businesses taking on debt.
Fixed-Rate Loans: Provide certainty in repayments, which can be helpful for budgeting. However, they come with restrictions, such as penalties for early repayments and missing out on potential rate reductions.
Variable-Rate Loans: More flexible, allowing additional repayments without penalties. Businesses also benefit from interest rate drops, but they must be prepared for potential increases.
Borrowing Cause vs. Borrowing Need Example:
A restaurant might believe it needs a fixed-rate term loan to cover equipment purchases (borrowing need). However, if the real cause of their financial gap is inconsistent cashflow due to seasonality (borrowing cause), a variable-rate line of credit could provide more flexibility.
c) Line of Credit / Revolving Credit Facilities
Working capital facilities help businesses manage short-term cashflow fluctuations. There are several options available, including:
Overdrafts: For covering everyday working capital needs.
Trade Finance: Provides funding for importing goods before receiving payment from buyers.
Invoice Finance: Unlocks cash from outstanding invoices, helping businesses smooth out cashflow gaps.
Equipment Finance: Used to purchase business-critical machinery, vehicles, or technology. Some loans include a residual or balloon payment at the end of the term to manage repayments.
Borrowing Cause vs. Borrowing Need Example:
An import business facing payment delays from international suppliers (borrowing cause) may think they need a business loan (borrowing need). However, a trade finance facility may be a better solution by bridging the payment gap without taking on unnecessary debt.
d) Full-Doc vs. Low-Doc Loans
Your ability to provide financial documentation can significantly impact the type of loan available to your business.
Full-Doc Loans: Require comprehensive financial records, such as tax returns, financial statements, and forecasts. These loans offer lower interest rates, higher loan amounts, and more lender options.
Low-Doc Loans: Suitable for businesses with irregular income or limited financial documentation. While they allow for faster approval, they usually come with higher interest rates and stricter security requirements.
Borrowing Cause vs. Borrowing Need Example:
A self-employed contractor who lacks formal financial statements (borrowing cause) might assume they cannot secure financing (borrowing need). However, a low-doc loan could be the right solution, as it accommodates non-traditional income verification.
3. How to Choose the Right Loan for Your Business
Selecting the right loan structure requires careful analysis of several key factors:
Business Cash Flow & Repayment Ability: Understanding your financial obligations and ensuring that repayments are sustainable.
Growth & Expansion Plans: Opting for financing that supports, rather than restricts, future business plans.
Risk Tolerance & Market Conditions: Evaluating potential interest rate changes and economic factors that may affect repayments.
Industry-Specific Considerations: Certain industries, such as manufacturing, hospitality, and transport, may require tailored financing solutions.
4. Working with a Finance Broker for a Tailored Approach
Given the complexities of commercial lending, working with a finance broker can be invaluable. A specialised broker can:
Identify the best loan structure for your specific business needs.
Negotiate better terms on your behalf, ensuring competitive rates and conditions.
Advocate for your business with lenders who may otherwise be hesitant.
With access to multiple lenders and deep industry knowledge, brokers can help businesses avoid costly mistakes and secure funding that truly aligns with their long-term goals.
Conclusion
Choosing the right loan structure is more than just securing funding. It’s about ensuring the financial health and sustainability of your business. By understanding your borrowing needs, cashflow position, and growth plans, you can make informed decisions that support long-term success.
If you’re unsure about the best loan structure for your business, let’s chat. As a commercial broker, I specialise in helping businesses navigate their funding options and find solutions tailored to their unique needs.
Michael Tran
Partner
Finesse Financial Services