Types of Loans and Sources of Repayment
There are many types of business loans available, with different structures and purposes. Payments on a loan may be interest only, principal including interest or principal plus interest and payable on a monthly, quarterly or annual basis. The loan may revolve or be a non-revolving, straight-line commitment. The maturity can be in days or years. Secured or unsecured. These all refer to types of structure.
Lenders provide loans for accounts receivable and inventory, working capital, equipment, acquisitions and real estate. These features help describe the purpose or intended use of the proceeds.
So, how many types of loans are there? There are four primary types of business loans! Three of the four loans are short-term and the fourth is long-term, all with a defined source of repayment.
The four types of loans and corresponding sources of repayment are:
TRANSACTIONAL LOANS, sometimes referred to as single-payment or bridge loans, are normally short-term loans and have a defined source of repayment from a specific event, i.e. the sale or liquidation of an asset. For example, a business needs a 90-day loan to purchase an asset with repayment from the encashment (payment in cash) of a Certificate of Deposit that is scheduled to mature at the same time. Borrowers will do this to avoid penalties for early withdrawal.
For example, a borrower wants to purchase a piece of property, subsequent to the sale of their property. In that instance, the credit union would provide a loan to purchase the property and bridge the gap, or period necessary to sell an existing property and repay the loan from the proceeds.
LINES OF CREDIT are normally used to support trading assets (inventory and accounts receivable) with repayment coming from the conversion of those assets.
As a company’s sales increase, inventory and accounts receivable will grow proportionally, if turn days (formula connecting the income statement's "Cost of Goods Sold" to the balance sheet's inventory) remain the same. A line of credit will support a percentage of the growth in the trading assets because of an increase in sales and provide the cash flow necessary to fund operations pending conversion of accounts receivable into cash. If sales are “on account” (meaning, cash has not yet been collected) it will create a cash flow timing difference and the need for a line of credit.
SEASONAL LOANS are a variation of a line of credit. As the name implies, they are utilized to fund temporary increases in inventory and resulting accounts receivable. However, this primary source of repayment is from a contraction of the trading assets rather than conversion.
This type of loan is common in the retail industry or any seasonal business where it is necessary to increase inventory in anticipation of sales during a holiday season.
TERM/INSTALLMENT LOANS are long-term and by definition greater than 12 months. Typically, term loans are utilized to acquire long-term or fixed assets with a maturity of something less than the useful life of the asset. The assets, for example equipment, are utilized over several operating cycles, and are generally repaid from profits from operating cash flows.
Generally, companies borrow money (source of cash) to increase an asset (use of cash) in anticipation of or in reaction to sales growth. It is important to understand the purpose and underlying cause for borrowings and match that with the most appropriate type of loan to avoid a possible mismatch in financing.
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