Why should the business be financed with loan capital?

It is acceptable business practice to finance your business with loan capital provided you can prepare a bankable business case. The financial institutions tend to lend to businesses with bankable business ideas or projects. You should however be 100% prepared with all the details of your project before you approach a financial institution for loan finance.

What is a loan?

A loan is the amount of money (secured or unsecured) provided by an individual or organization to another individual or organization at an interest with an arrangement to pay back the funds to the lender over a period of time.

Sources of business finance

The following are the sources of business finance;

Advantages and disadvantages of loan financing

You should consider the advantages and disadvantages of loan finance before you opt for loan capital finance from financial institutions.  The advantages and disadvantages are as follows;

Advantages of loan financing

The loan financing has the following advantages;

• A loan is easy to secure provided you have a bankable business idea
• The loan is secured for a given period and it will only appear on the balance sheet during that period.
• Loan capital does not dilute owners capital
• Loan capital provides some degree of certainty in planning
• There is a tendency to effective utilize the loan  capital  as the loan has to be paid back
• The interest charge is tax allowable ending up in reducing the tax payable
• The owners of a legal entity are to a certain extent protected in case the legal entity is liquidated.
• The cost of borrowing  tends to be lower than the expected return to equity capital

Disadvantages of loan financing

The key disadvantages are as follows;

• The interest is payable even when the business is not doing very well
• The loan agreements provide for penalties for  late repayment of principal and interest
• The borrower has to provide security for the loan
• In some jurisdictions, there are regulatory requirements restricting the amount of the interest allowable as an expense.

What do you need the loan capital for?

• When your capital structuring arrangement provides for loan capital
• Financing capital expenditure
• Working capital

What will lenders consider in evaluating your project?

• The bankable business idea should be supported by the business plan
• The cash flow should support loan repayments
• The borrowing organization should have free assets on the balance. The free assets are those assets which have  not been used in securing a loan.
• The quality of security the business is offering to the lender
• Whether the business is managed in accordance with best corporate governance practices

Conclusion

The way the company assets are financed has an impact on the overall return to the owners as loan capital and equity capital have different expected returns. In addition the amount the owners of business can inject into the business in the form of equity is often limited.  It is therefore quite in order to finance your business with loan capital provided your business meets the expectations of the lenders

 

Author: John Muhaise-Bikalemesa,
Director Big Drum Advisory Services,
john.muhaise@bigdrumassociates.com

 

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