Understanding the different types of commercial loans can be a challenge if you’re not in the finance sector. Before I became an accountant, I spent 12 years working in the banking industry. During my time there, I opened accounts, underwrote loans, worked on loan collection, and restructured problem loans. In summary, I have been involved in the complete lending cycle process from start to finish. With that experience, here’s a high-level introduction to the different types of commercial loans:
Revolving Business Line of Credit
A revolving business line of credit, which is similar to a credit card, has a loan limit that you can draw on up to the credit limit. Typically, a business would use a line of credit to fund working capital needs. The monthly payment is interest only, with principal due at maturity. Interest on the line of credit is usually a variable rate based on prime rate plus the lender margin. There is usually no prepayment penalty for paying off the principal before the maturity date. A standard line of credit has a 12-month period and typically may be renewed upon maturity.
Most banks require businesses to pledge collateral to secure the revolving business line of credit. Typical types of collateral include accounts receivable, inventory, equipment, and business personal property. Note that business personal property is not the same as real property such as buildings and land. Business personal property includes, but is not limited to, office supplies, furniture, fixtures, and computers.
Frequently, the lender will also impose financial covenant requirements to analyze the borrower’s ongoing operations and to predict their ability to repay the debt. Common covenants can include current ratio, debt to net worth, minimum net income threshold, debt service coverage ratio, and line rest requirements (meaning the line needs to be paid down to zero for a specified number of days).
The financial reporting requirements for a line of credit can include business’ and owners’ federal tax returns and financial statements. Additionally, the lender may ask the borrower to complete a borrowing base certificate which calculates whether the borrower’s eligible accounts receivable, inventory, and fixed assets can support the outstanding loan balance and the loan limit.
Term Loan and Non-Revolving Line of Credit
A term loan can be either a short- or long-term loan. It is usually obtained for a specific reason, such as the purchase of machinery or equipment. The loan is amortized over a specified period of time per the loan agreement, and monthly payments include principal and interest. The interest rate could be fixed or adjustable during the life of the loan. Collateral, financial covenant, and financial reporting requirements are similar to those of a business line of credit.
A non-revolving line of credit is where a borrower is given a loan limit and can draw against the line. However, drawing against the line will reduce the loan limit and it becomes a term loan. This is usually used by a borrower when they have multiple large purchases to make.
A construction loan is a short-term loan used to fund the construction of a real property. It is an interest-only loan secured by the real property. In addition to tax returns and financial statements, a lender usually requires the following information to be submitted with the loan application: full set of plans, budget, feasibility study to support the business plan for the proposed construction, and a listing of current inventory (other real estate projects). Typically, a lender would order an appraisal report which uses comparable properties to provide a value estimate for the proposed property to be built.
After a construction loan is made, a draw request will need to be submitted by the borrower with supporting documentation. This can include a construction in progress report, copies of invoices to be paid, and lien waivers from the vendors. Each item on the budget is monitored closely by the lender to ensure costs stay within the budget. Additionally, the lender also carefully monitors costs in excess of billings account and billings in excess of costs account.
If the intent is to market and sell the property after construction is complete, then proceeds from the sale of the property will be applied against the loan balance. If the intent is to build and hold the property, then the loan balance will be converted to a commercial real estate loan.
Commercial Real Estate Loan
A commercial real estate loan is a permanent loan that typically ranges from five years to 20 years and is secured by the property. The loan is amortized over a specified period of time per the loan agreement. Its rental income is used to pay down the loan balance. The lender will analyze rental income generated from comparable properties, current rental market condition, and executed leases on the subject property to assess whether net operating income from the property supports the servicing of the loan. If net operating income is inadequate, the lender may ask the borrower for a first or second lien on another rental property, as well as the rental income from the additional property to support the loan payments. Common financial reporting requirements include tax returns, financial statements, copies of leases, and rent roll reports.
The lender’s loan file usually includes an internally prepared loan amortization schedule.
Asset Based Loan
Asset based loans are typically made to companies with a higher business risk and those with cash flow problems. Interest rates on the asset based loan are higher than those of regular loans. The lender relies on the borrower’s accounts receivable to repay the debt. As such, they closely monitor the borrower’s accounts receivable and inventory. Lenders may require daily or weekly financial reporting on the collateral used to secure the loan as well. The lender also requires quarterly or annual collateral exams to be conducted.
In a collateral exam, the bank sends a collateral examiner to the borrower’s site to perform an examination of its books and records, conduct an inventory test count, perform an inventory valuation estimate, examine fixed assets, and perform appraisal on the fixed assets. The lender will use the report produced by the collateral examiner to evaluate the credit risk and use that information to structure its loan and to assess the borrowing relationship.
These are the high-level summaries of common types of business loans. Our accounting, consulting, and services team can assist you with cash flow management and projection. We can also assist with any of the bank-required financial reporting requirements, including preparation of business and individual tax returns, as well as compiled, reviewed, or audited financial statements. Contact a Clark Nuber professional if you have any questions.
Grace Chu is a manager in Clark Nuber’s Accounting and Consulting Services team.
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