How Bank Loans Work: Advantages, Disadvantages and Things You Need To Know

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Bank loans have been one of the most traditional ways for companies to borrow money and get access to capital and invesment to pursue their business goals. This article explains how a bank loan works and explores its pros and cons, covering the following topics:

  • What are bank loans?
  • How do bank loans work?
  • Advantages of bank loans
  • Disadvantages of bank loans
  • Alternative to bank loans: revenue-based financing
  • Some last words

What are bank loans?

Bank loans are term loans provided by bank lenders for your business to meet your financial needs. Interests will be charged on outstanding balances, and you need to make repayments according to a fixed schedule.

To apply for a bank loan, you are usually required to provide property or equipment as collateral. In the event of default, these assets will be seized and sold by the lender to recoup its loss.

How do bank loans work?

‍An application for commercial loan typically begins with submission of application forms, along with documents such as your company’s certificate of incorporation and financial statements.

Upon collection of all required documents, the bank performs credit analysis on your business, taking into account a number of factors to determine whether a loan should be granted.

These include your company’s financial statements, cash flow, business plan and asset coverage ratio, but to name a few.

If your loan application is successful, the bank will provide you with cash, which is to be repaid at a certain interest rate.

Normally, you will also need to provide tangible assets as collateral. In the event of default, these assets will be seized and sold by the bank to recover the debt amount.

No doubt, banks have played a major role in financing traditional businesses.

Nevertheless, bank loans may not be suitable for newer, innovative and fast-growing e-commerce companies. This is because these companies tend to have fewer pledgeable assets and higher risk-return profiles.

With these unique features, these companies may find it difficult to qualify for loans under the conventional credit assessment model used by bank lenders. Lack of standard financial statements could also be a hurdle to obtaining bank loans.

Pros and cons of bank loans

Advantages Explanation
Clear loan terms Interest rates and repayment amounts are fixed at the outset, making it easy to plan your budget and predict spending.
No equity dilution Bank lenders do not share ownership of your company.
Relatively low interest rates Interest rates on bank loans are usually lower than that in other financing methods (e.g. inventory and invoice financing).
Disadvantages Explanation
Complicated application procedures Bank loan applications require collection and submission of lots of paperwork. The process could be taxing and time-consuming.
Long turnaround time The loan approval process could take months.
Collateral required E-commerce companies may not have adequate tangible assets to serve as collateral.In these circumstances, banks may require that the loan be secured against your personal assets.
Difficult to qualify Some bank lenders require that businesses be established for a certain period of time (e.g. 2 years or even more) in order to be an eligible applicant. Credit assessments are not easy to pass.
Rigid repayment schedule Repayments must be made on schedule. Loan default could lead to seizure of collateral. It would also affect your credit score, making it harder for you to borrow from financial institutions in the future.
Interests on outstanding balance Interests accrue on unpaid amounts. Cost of debt could be high if you fall behind on loan repayments.
Restrictive covenants There may be restrictions on how you use the borrowed money.

Learn more: E-commerce Lending: Loan Options and Alternatives

Alternative to bank loans: revenue-based financing

Revenue-based financing (RBF) has gained popularity among small and medium businesses, startups, e-commerce companies in recent years.

In essence, revenue-based financing is an alternative financing method to bank loans in which companies receive funding based on future revenue.

After putting in an application for revenue-based financing, risk assessments will be conducted on your business.

If you are eligible for funding, capital will be remitted in as soon as 48 hours.

Contrasted with borrowing money from banks (borrow-based finance) and repaying fixed amounts regularly, revenue-based financing gives you ample flexibility in repayment.

Under the RBF approach, RBF platforms (which provide funding) will share a small percentage of your monthly revenue as repayment for the capital provided.

If you have a slow month, you pay back less; if business is good, you pay back more.

Ultimately, repayment is capped at a predetermined amount, which is usually the capital plus a small flat fee.

Pros and cons of borrowing money via revenue-based financing

Advantages Explanation
Flexible repayment Repayment amounts are directly proportional to revenue. There is no pressure to ‘keep up with loan payments’.
No interest on outstanding balance Repayment is capped at the capital plus a flat fee.
No collateral required Makes access to capital easier for asset-light e-commerce companies.
No restrictive covenants There are no restrictions on how you use RBF funding.
Streamlined application process Application is quick and easy. For example, Choco Up’s data integration system facilitates risk analysis, enabling eligible applicants to get a preliminary offer in just 10-15 minutes. If everything works out, funding could be ready in as soon as 48 hours.
No equity dilution RBF platforms do not take equity or board seats at your company.
Disadvantages Explanation
Pre-revenue companies may not be eligible Provision of funding and repayment are both dependent upon your company’s monthly recurring revenue. With little or no revenue, it could be difficult to obtain RBF funding.

Learn more: Merchant Cash Advance (MCA): Everything You Need To Know

Should you consider bank loans or revenue-based financing?

Just like each individual is unique, no two companies are the same. Long-term loans might suit one company for their relative security and assurance, whereas another company might be better suited for RBF due to its adaptability.

Both options have their advantages and disadvantages, and it’s up to the company’s leadership to evaluate all choices presented to them before selecting the best option for their needs.

There is no such thing as the best financing option for businesses, only a financing option that best serves your business needs.

To help you find the right fit for your business, Choco Up has compiled a table comparing bank loans and revenue-based financing.

Revenue-based financing Bank loans
Application process Simple Complex and time-consuming
Approval process Quick Slow
Fees Flat fee only Interest on loan plus other fees (e.g. drawdown fee, facility fee, early repayment fee, etc.)
Interest on outstanding balance? No Yes
Available funding Depends on revenue performance Depends on credit score and history
Collateral Not required Company or personal assets
Repayment schedule Flexible Fixed
Repayment amount Proportional to monthly revenue Fixed (principal plus interest)
Restrictions on use of funding No Usually yes

Interested in learning more about raising capital for your company? Check out the following guides we’ve prepared for you: