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How to choose the right business loan

April 28, 2017

There are lots of things to think about if you’re considering taking out a business loan.

The UK’s business lending market includes a wide range of providers offering subtly different types of business loans. Some are aimed at a particular type of business, or companies of a certain size or those operating in a specific sector.

With a wide range of business loans available it’s important to first get a basic understanding of the different options you have when it comes to borrowing money to fund your business.

Here are some of the key considerations you need to bear in mind when sourcing a business loan for your firm.

Basic criteria for business loans

Whichever business loan provider you go to, there are a few basic lending criteria that almost everyone will look at, so it makes sense to be prepared for the common questions.

One of the first questions will be, ‘How long has the business been trading?’, and lenders will usually want to see a minimum of 1–2 years of history.

If your business is younger than this, there are still some options out there such as start-up loans or government grants.

The next important metrics are your annual turnover and profit margins. These are the most basic indicators of your firm’s health — which not only demonstrate your ability to generate cash, but also inform your affordability for repaying a loan.

Along the same lines, it’s a common practice to compare the ratio of the loan amount to your monthly turnover. The standard maximum is a 1:1 ratio, i.e. you normally can’t borrow much more than one month’s typical turnover.

Finally, most lenders will look at your credit history — business, personal, or both — to check for serious issues like CCJs, and other potential red flags like repeated late payments.

Since the lender will be relying on a monthly payment from you, it makes sense that they want to see what your past record is like.

If your business satisfies these initial eligibility checks, from this point there are a few things to consider to choose the most suitable type of business loan and the right lender for your situation.

Security

The concept of security is important in many types of business funding, and it’s one of the things you should think about when you’re looking for a loan.

Secured loans

On one side of the coin are secured loans. As the name implies, these business loans are ‘secured’ on valuable assets owned by your business such as commercial property, machinery, vehicles and stock.

The basic idea is that the lender takes a legal debenture over the asset(s), so if you stop making the loan repayments the lender can sell the asset(s) you’ve provided as security to recover their losses.

For this reason, the resale value of the security determines how much you can borrow. With appropriate security, you may be able to borrow up to 75% of the value, and going the secured route can also mitigate risk in other areas of the application.

For example, if you wanted to borrow £10,000 but were only turning over £5,000 per month, the lender would probably question your affordability — because the ratio of loan amount to turnover is higher than they’re comfortable with.

However, if you had a piece of machinery worth £15,000 to use as security, this might make the difference between a ‘no’ and a ‘yes’.

Unsecured loans

On the other side of the coin are unsecured loans, which don’t involve any security and therefore require businesses that are stronger in terms of turnover and profitability.

Lenders offering unsecured business loans will want to see good profits and a few years of trading history — and they’ll usually ask for a personal guarantee, which brings the personal net worth of the business director(s) into play.

Flexibility

Business loans often have a fixed term and fixed monthly payments — but if your business isn’t easy to predict, you may prefer a flexible option.

These days, lots of business loan providers offer revolving credit facilities, which are characterised by an overdraft-style maximum that allows you to borrow when you need.

Usually, aside from setup fees you only pay interest on what’s outstanding, so the credit line can sit idle when you don’t need it. Having this kind of safety net in place can be very useful for businesses that are variable month-on-month.

Characteristics of your business

Finally, it’s worth thinking about which types of loan fit your business best in terms of how it trades. For example, if you trade with customers on credit and get paid via invoices with payment terms, invoice finance helps you access this money early.

Or perhaps you make most of your revenue from card machine payments — in which case, it would make sense to look into merchant cash advances, which are a kind of unsecured funding line based on your card terminal history.

There are also lenders that specialise in particular sectors like construction or recruitment — while they’re by no means the only options available, you might find their product includes something that sets them apart from the pack.

Conclusion

Choosing a business loan is more complicated than you might think. Is a fixed-term loan or a flexible facility best? Do you have security, or are you looking for an unsecured option?

Answering questions like these will help narrow down your options, and set you on the right path.

For a more in-depth guide to the pros and cons of the various types of business loans have a look at the Business Loans Guide 2017 which is free to download.

Further resources

A business finance marketplace like Funding Options – which has been selected by HM Treasury as part of the Bank Referral Scheme – could help you find the right business loan.

These other ByteStart guides can also help you to find funding for your business;