A commercial loan is a debt financing arrangement between an enterprise and a financial institution. It is usually used to finance major capital expenses and / or cover operating costs that the company would otherwise not be able to afford. Expensive start-up costs and organizational difficulties often prevent small businesses from directly accessing the bond and equity markets for funding. This means that, unlike individual consumers, small businesses have to use alternative credit options such as lines of credit, unsecured loans, or term loans.
- A commercial loan is provided between a financial institution and a business and is used to finance operating and capital expenditures;
- In most cases, a borrower needs to provide collateral such as real estate or equipment;
- Companies are generally required to provide financial statements to prove their ability to pay;
- Although most commercial loans are short-term, they can be “rolled over” or extended to extend the term of the loan.
Types of commercial loans
Commercial loans come in different forms. You’ve probably heard of some of them, and some will be new.
- Postponement – the supplier ships the goods to the buyer, and receives the money later. Usually, a delay is given for 30-90 days. But there are also more protracted periods;
- Installment is similar to deferral with one exception. In case of deferred payment, payment is made in one-time in full amount. And with installments, there is always a debt repayment schedule: once a month, once a quarter, etc;
- Advance payment or prepayment – the buyer-creditor transfers money to the supplier-borrower who undertakes to ship the goods or provide the service after a certain period of time.
Commercial loan forms
- Lump-sum payment. This is the most popular option. The terms of payments and their size are clearly prescribed in the contract. For example, in the contract, you can specify that as an advance payment, the buyer pays 30% of the cost, then 50% at the time of shipment and another 20% within 15 days;
- Consignment. Consignment is used in the sale of goods, the demand for which is difficult to predict. In fact, such a loan is similar to a deferral. The manufacturer ships the goods to the buyer who will return the money for it only after the subsequent sale. This method of settlement is often used when selling products to intermediaries;
- Promissory note. A bill of exchange is a security that provides for a deferred payment or unconditional payment for goods at a certain time. This paper confirms the obligation of the borrower to pay money to the creditor immediately after he presents the bill for payment.
For example, company A sells raw materials to company B. Since B has no cash, companies issue a promissory note. Company B is the drawer, company A is the drawer. In order to receive its money, firm A needs to present the promissory note to firm B.
A bill of exchange can be transferred from one organization to another, like a security. For the creditor, this means that at any time he can sell the bill to a third party who has the right to resell it or present it to the drawer.
How commercial loans work
Commercial loans are granted to various business entities, usually to meet short-term financing needs for operating expenses or to buy equipment to make the manufacturing process easier and more efficient. In some cases, the borrower may extend the loan.
These loans often require the company to provide collateral, usually in the form of fixed assets, which the lender can take away from the borrower in case of default or bankruptcy. Sometimes, cash flows from future receivables are used as collateral for a loan. A commercial real estate mortgage is a form of commercial loan.
Commercial loan term
The term is also not regulated by law. You can take a loan for any period. Sometimes the lender and the borrower think that the loan term is equal to the grace period specified in the purchase agreement. But then the question arises: what to do if the debtor does not pay on time?
It is best to indicate in the contract that the term of the commercial loan is valid until the full actual payment for the purchased goods. That is, even in case of delay, the borrower will not be able to recognize the contract as expired.
For late payment, a percentage can be set – forfeit. Sometimes it is confused with interest on a loan, but the penalty applies only to the overdue part of the loan and is similar to a fine.
The borrower’s creditworthiness plays an important role when a financial institution is considering a commercial loan. In most cases, a business applying for a loan will have to provide documentation that shows that the business has a regular cash flow. This makes the lender sure that the borrower is able to pay off the loan in accordance with the agreement.
If a company is approved for a commercial loan, it can expect to be paid an interest rate that matches the base rate of the loan at the time the loan is disbursed. Banks usually require the company to provide monthly financial statements for the loan period and often require the company to insure any larger items bought with the borrowed money.
Types of commercial loans
While a commercial loan is most often a short-term financial assistance, some other financial institutions offer revolving loans that can be extended indefinitely. This allows the business to receive the funds it needs to maintain its current operations and to pay off the first loan within the agreed period.
Thereafter, the loan can be transferred to an additional or “extended” loan period. A business will often look for a revolving commercial loan when it needs the resources it needs to handle large seasonal orders from specific customers but still be able to supply additional customers with goods.
How to draw up a commercial loan agreement
You can draw up a commercial loan agreement in a simple written form. Be sure to indicate:
- loan amount;
- loan terms;
- interest rate, if any;
- grace period for payment;
- payment schedule;
- the procedure for a forfeit collection;
- responsibility and rights of the lender and the borrower.
If a commercial loan is interest-free and its cost is included in the price of the goods, then the deferral or installment plan is formalized as separate clauses in the contract. If the loan is interest-bearing, it is better to draw up an additional loan agreement with a mandatory reference to the main purchase and sale agreement.
Advantages and disadvantages
The main advantage of a commercial loan is that the interest on it is much lower than on a bank loan. And the application procedure is much simpler, sometimes the terms of a commercial loan are prescribed directly in the main agreement, without drawing up a separate document. Such a loan provides the buyer with the opportunity to receive the goods now and pay later; for the seller – to receive payment (in part or in full) for the goods in advance. This scenario is beneficial to both parties since temporarily free funds can be put into circulation.
The disadvantage of a commercial loan is that its amount is limited – on the one hand, by the size of the seller’s inventory, and on the other hand, by the level of the buyer’s creditworthiness. The supplier is at risk of a possible refusal of the buyer to pay the bills or his bankruptcy. The buyer also bears the risks of an advance payment, prepayment for goods that may not be shipped but of inadequate quality. Another disadvantage of a commercial loan is its short-term nature.