There comes a time when a small business needs to access capital. Perhaps there are plans for expansion or there is a need to fund a new marketing plan. Loans play a critical role in the lifeblood of small businesses in Canada. This article explores how a small business loan works.
What is a small business loan?
A loan is a form of debt incurred by small a business. The lender, usually a corporation, financial institution, or government, advances a sum of money to the borrower. In return, the borrower agrees to a certain set of terms including any finance charges, interest, repayment date, and other conditions.
What is a small business loan used for?
Most small businesses request financing to purchase fixed assets and to support day to day working and operational capital expenditures. This could include cash flow, vehicles, upgrading equipment, inventory, renovations, staffing, marketing, tax payments, or supplier payments.
What are the different types of small business loans?
Loans can be classified into secured and unsecured. A secured loan is secured against collateral or an asset. Collateral examples include personal property, stocks, or bonds. Secured loans are generally for a higher borrowing amount, carry a lower interest rate, and have long repayment periods.
Unsecured loans do not require an asset or collateral. They require a higher credit score and typically have a higher interest rate. Critical qualifying factors are your credit score and credit history. These types of loans are generally used for credit card purchases, education, and personal loans. Most lines of credit and business credit cards are unsecured.
The term or length of time of a loan can be short or long. A short term loan is generally repaid within a few months to a year. The entire amount is paid back in full on a specific date. Most short term loans are valued at less than $100,000. Short term needs such as building inventory, accounts payable, or finishing a project are reasons for a short term loan. Short term loans are typically easier to obtain approval but less flexible with higher interest rates.
On the other hand, long term loan repayments can last a few years up to several years. Long term loans are generally required for larger amounts or for dealing with bigger transactions such as business expansion, acquisitions, or refinancing. Long term loans involve much more scrutiny to determine creditworthiness and generally carry a lower interest rate.
What are the costs of a small business loan?
The cost of the loan is determined by the amount the lender will charge. This amount, or interest rate, will be calculated based on the current index rate for Canada, your perceived credit risk, and the length of the loan term. A long term loan with a good credit rating will carry a lower interest rate cost than a short term loan with a poor credit rating.
The interest rate may be fixed or variable. A fixed rate will not change throughout the term of the loan. A variable rate, based on the index rate for Canada, will change as the index rate fluctuates.
There may also be fees to pay before, during, and after the loan process. Fee examples include application, cheque processing, documentation, late payment, prepayment, or returned payment.
Qualifying for a small business loan in Canada
The application for a small business loan may require various documents to verify your information:
Business Plan– You can help prove why you need a loan and how you intend to use the proceeds by providing the lender a copy of your business plan. This document will help earn the lender’s trust.
Bank statements – Lenders may wish to see the cash flow of your business
Balance Sheet – These are typically required so that your lender can evaluate your total assets and liabilities.
Income statement –Your income statement will let your lender see what your expenses are, how much your costs of goods sold are and what your net income is.
Tax Returns – Your lender will use this to confirm whether the income you claimed is the same as what you reported with the CRA. Any discrepancies can jeopardize your application approval.
Personal Financial Documents – Some lenders may want to see your credit report to understand your financial health.
Resumes for all business owners and key employees
Information about the assets to be purchased, including a copy of the sales contract or purchase agreement, if applicable.
Lenders will scrutinize a borrower’s profile to determine a small business loan approval. Here are some items to keep in mind when making an application:
Credit Score – lenders almost always check the small business owner’s personal credit. This demonstrates whether the borrower can make payments on time. A high score improves the likelihood of a loan being approved and a more favorable interest rate.
Collateral – collateral helps the lender mitigate losses if there is a default. Loans are easier to get and have lower interest rates when they are secured by collateral.
Cash Flow – this will be measured using the forecast created in your business plan. You will need to be clear on what type of financing you need, how you intend to use the proceeds, and how much you need to achieve your targets.
Age of Business – new businesses and start ups will have more difficulty in getting funding than a mature business. Traditional banks will look for 2 years or more.
Current debt load – a business with too much debt will have a difficulty getting a new loan.
Industry – the lender will assess the risk of your business during the approval process. Some industries carry more risk than others.
Lack of credit history, managerial experience, and assets to pledge for collateral are the main reasons small businesses can have trouble accessing financing.
Where can you get a small business loan in Canada?
Traditional Banks – the “big banks” are a common source of capital for small businesses.
Credit Unions: financial cooperatives that provide traditional banking services to their members. They are not for profit and can sometimes offer better rates on loans than a traditional bank.
Microloans: intended to help small businesses who may have trouble securing financing from a bank or credit union. Normally less than $50,000. Many are offered by nonprofit or government organizations. Microloans often come with restrictions on how you can use the proceeds.
Community loan funds: non-profit organizations that provide loans to local initiatives and fostering entrepreneurship in the in the community.
Canadian Small Business Financing Program: a loan program in collaboration with financial institutions where small businesses or start ups with less than $10 million gross revenue can apply for financing the cost of land improvements, renovations, and equipment. More information can be found here.
The Business Development Bank of Canada: a federal development bank with a mandate to help create and develop Canadians businesses through financing, growth and transition capital, venture capital and advisory services. The bank is focused on small and medium sized businesses. You can apply online for up to $100,000. More information can be found here.
Online lenders are considered an alternative to traditional bank loans. The difference is how technology is used, the approach to the small business loan process, and the model used to evaluate a borrower’s creditworthiness.