WHAT TYPE OF LOAN?
When you set out to borrow money for your firm, it is important to know the type of loan you want and its duration. There are two basic kinds of loans -- lines of credit and installment loans -- and two general categories of loan length -- short‑term and long‑term.
The purpose for which the funds are to be used is a very important factor in deciding what kind of loan to request. There is also an important connection between the length of the loan and the source of repayment. Generally, short‑term loans are repaid from the liquidation of the current assets (i.e., receivables, inventory) that are financed, while long‑term loans are generally repaid from earnings.
Line of Credit
A line of credit is an arrangement in which the bank disburses funds as they are needed, up to a predetermined limit. The customer may borrow and repay repeatedly up to the limit within the approved time frame (usually one year).
An installment loan is an agreement to provide a lump sum amount of money at the beginning of the loan. The loan is paid back in equal amounts over the course of a number of years.
A short‑term bank loan can be used for purposes such as financing a seasonal buildup in accounts receivable or inventory. Lenders usually expect these loans to be repaid after their purposes have been served: for example, accounts receivable loans when the outstanding accounts have been paid by the customers and inventory loans when the inventory has been sold and cash collected. Short‑term loans are generally repaid in less than a year.
A long‑term loan is usually a formal agreement to provide funds for more than one year, and most are for an improvement that will benefit the company and increase earnings. An example is the purchase of a new building that will increase capacity or of a machine that will make the manufacturing process more efficient and less costly. Long‑term loans are usually repaid from profits.