Sources of Capital: Financial Institutions
As we continue our series on the different sources of working capital for your business, we will now take a closer look at the pros and cons of borrowing from a financial institution.
Borrowing from a bank will typically come in the form of either a term loan with a defined repayment schedule or in the form of a line of credit. Your needs and circumstances will often dictate which of these two structures would make the most sense for you. A term loan would probably make the most sense if you need a large, one-time infusion of cash to buy equipment needed to get your business off the ground, where a line of credit would be more beneficial if you periodic cash inflows to cover advance inventory payments.
One of the primary benefits to sourcing capital from a bank is that you will maintain 100% ownership of your company. Also, while you won’t get the repayment flexibility that you may have when you borrow from a friend or family member, you can find solace in the fact that the financial institution that you engage with will be more reliable and likely to honor your agreed upon terms (that said, you need to do your homework when it comes to finding the right bank to partner with).
As with every other source of capital, however, there are potential downsides to borrowing from a financial institution. You will need to have a solid credit score to qualify for financing, and the level of risk that the bank associates with your project could require you to pay a higher interest rate. If your business is still in its early stages, some banks may also require you to present a business plan which can be costly and time-consuming to prepare. Getting a loan or line of credit with a bank will almost always require putting down some type of collateral in the form of business or personal assets.
Once you have secured a loan from a financial institution, there will often be financial reporting requirements and debt covenants that must be met throughout the term of the arrangement. The covenants that you will be required to maintain could potentially affect the way that you operate your business, so you must analyze the situation thoroughly before you enter into an agreement.
Overall, sourcing your capital through financial institutions can be a smart move if you are in a position that makes you attractive to a lender. While there will be plenty of hoops to jump through, maintaining 100% ownership in your business is usually worth the trouble.
About the Author
Tim Peters is a consultant with Morrison, working primarily in our Business & Accounting Advisory practice. To get in touch with Tim, please find contact information for Morrison here.