Loans
Background
Businesses often need additional cash flow to grow or get through tough times. Food truck businesses are no different. A business loan can help keep the food truck business afloat and even help it get ahead of the competition.
However, the decision to take a loan should never be taken lightly because of the risks. Debt is inherently risky, and loans put a company in debt. An economic downturn can exacerbate this risk for a business. A business's cash flow might take a big hit when the economy is in a recession. This will make it more difficult for the company to repay its loans, thereby exposing the business to the risk of bankruptcy.
That is why it is essential to understand how loans work. Loans are classified as either secured or unsecured.
Secured loans require some form of collateral, often assets owned by the business, to secure them. The company could lose such assets to the lender if it cannot repay the loan.
Unsecured loans do not require collateral, but the business must meet predefined income and credit requirements. Companies with poor incomes or credit histories usually cannot receive unsecured loans. Such loans also have higher interest rates than secured business loans, making individual loan payments more expensive.
Types of Small Business Loans
Several small business loans are available to food truck businesses. Choosing the right type matters for success.
Equipment loans
This is a good option for financing the purchase of new food trucks or equipment for the business. They typically have low-interest rates and flexible repayment terms. However, they often require a down payment, and the lender could repossess the equipment if the business defaults.
Working capital loans
A working capital loan is ideal when a food truck business needs extra cash to cover day-to-day expenses or take advantage of events and new business opportunities. They usually get approved quickly with short and flexible repayment terms. However, the interest rate for this type of loan is higher than others, and the business could be at risk of default if it does not use the borrowed funds wisely.
Business Line of Credit
A business line of credit is a revolving credit line that borrowers can draw from as needed. It works like a credit card but with higher funding amounts. It also has lower interest rates than credit cards and requires interest payment on only the portion of the line of credit used.
Business term loans
This is probably the most popular type of business loan. It is a lump-sum loan repaid with fixed, regular payments over a set time, typically between two to five years. They can be used for various purposes, such as to finance the purchase of new equipment and upgrades or expand the food truck business.
Although the best loan option will depend on the food truck business' funding needs, it is often ideal to go for one with low-interest rates, longer repayment tenures, and higher loan amounts.
Simulation
In the simulation, the bank offers unsecured, business term loans over five years with debt-to-equity requirements. Before moving to the factors food truck businesses need to consider when taking a loan, it is vital to know when to take it.
When should a business take a loan?
There are a few signs that indicate when to consider taking a loan:
- Poor cash flow: Whenever the business struggles to pay for inventory and other operating expenses, it is time to think of getting a loan.
- Insufficient capital for equipment and expansion: Loans can be a lifesaver when the business does not have the cash to buy a new food truck or other equipment outright.
- Low-interest rates: It might be a good time to get additional capital when the business is doing well, and loan interest rates are low.
Factors to consider when taking a loan
As mentioned earlier, taking a loan for a food truck business is a big decision. Here are the factors you need to keep in mind when taking out a business loan for your food truck:
1. Purpose of the loan
The purpose of the loan has to be known. Whether it is for expansion, upgrades, operating expenses, or an emergency fund in anticipation of unexpected events, it does not matter. Without a clear purpose, abuse is inevitable. A clear purpose will also answer the question of the loan amount required.
2. Loan amount required
The purpose of the loan will determine how much is required. The simulation offers three loan amounts, minimum, average, and maximum, depending on a business' debt-to-equity ratio. It is considered responsible borrowing to borrow just what is needed to achieve the loan's purpose. That is because the company will have to pay more than the original amount borrowed due to interest.
3. Loan term
The loan term refers to the total repayment period. Because interest is paid for the duration, shorter repayment lengths mean lower total interest costs. The repayment period for loans in the simulation is set at five years. Repaying the loan earlier than the due date reduces the actual interest paid by the business.
4. Interest rate
The interest rate is the percentage of the loan amount the lender chargers as interest. Getting a loan at the lowest possible interest rate is the first step in succeeding with loans. Two types of interest rates exist: fixed interest and variable interest. With a fixed-interest loan, the bank sets the interest rate for the duration of the loan. The monthly repayments stay the same even when the Central Bank changes its rates. Variable interest loans have repayments that can go up or down, depending on how the Central Bank's rates fluctuate.
The bank in the simulation offers a fixed-interest rate loan.
How is the interest rate determined?
Commercial banks set their interest rates based on the prevailing rate set by the Central Bank. They then benchmark their rates against what competitors are charging and adjust accordingly.
The role of the Central Bank
The goal of the Central Bank in every economy is to maintain price and financial stability. They do this by controlling the key or policy interest rates. These rates are offered to commercial banks, which in turn add their margin and offer slightly higher rates to the public.
Relationship between Gross Domestic Product (GDP) and Interest Rate
The Central Bank adjusts its interest rates based on the country's economic health as indicated by its Gross Domestic Product (GDP). When the economy is booming, the Central bank can increase interest rates to make credit more expensive and reward savings. When the economy is in a recession, it can lower the rates to stimulate further investment and demand. The commercial bank rate will also drop when the Central Bank lowers its interest rates. Hence, businesses often find some of the lowest interest rates during a recession.
Countries usually go through a 10-year cycle of economic booms and recessions. The simulation compresses this 10-year cycle to one in-game year.
Base interest rate
At any given time in the simulation, the bank's base interest rate (offered to companies with almost no debts) can be calculated thus:
Central Bank rate + Bank margin = Base interest rate
Current interest rate
This is based on the bank's perceived risk of loaning money to a specific business at a given time. Depending on the business' income and credit history, the bank may consider the company a medium or high-risk enterprise and offer loans at a higher interest rate than its base rate.
Debt-to-Equity Ratio and Current Interest Rate
In the simulation, the bank uses a company's debt-to-equity ratio to assess its creditworthiness and classify its risk of loaning money to it. The debt-to-equity ratio indicates how much a company finances its operations with debt instead of equity or retained earnings. It is calculated by dividing total liabilities by total equity. The bank considers companies with low debt-to-equity ratios as low-risk businesses. Those with a high debt-to-equity ratio are considered high-risk businesses.
The current interest rate for low-risk companies is lower than that for high-risk businesses. Companies classified as very high-risk (highest debt-to-equity ratio) cannot take loans from the bank.
To improve creditworthiness, the company can pay off its loan, increase its profitability, or improve its inventory management.
5. Loan Fees
Aside from the interest rate, businesses will also have to pay other fees when taking out a loan. These fees often add up to a substantial amount, so they are worth mentioning. However, businesses may end up negotiating them with the bank. They include:
Processing Fee: Usually a small, fixed amount; banks charge this fee for processing the loan application. The bank in the simulation charges 5% of the loan principal for this fee. It is the only loan fee the bank charges.
Origination Fee: A fee charged by the bank for providing the loan. It is usually a percentage of the loan the business pays upon receiving it.
Commitment Fee: Banks sometimes charge this as compensation for promising to provide the loan. Usually, a percentage of the loan amount is paid when the loan is approved.
Exit Fees: Banks sometimes include an exit fee when the loan is repaid early. Also called a prepayment penalty, the fee compensates the lender for the interest they would have earned if the borrower had held the loan for the entire term.
6. Default risk
There is always the risk of being unable to pay back a loan as a business. When this happens, the company is considered in default. This has severe consequences for the business and the owners.
In the simulation, companies that default on their loans declare bankruptcy. Budgeting is a wonderful way to minimize default risk. It helps to show the maximum monthly payment a company can afford. Knowing this amount can also contribute to the size of a loan the business can take.
The financial section is handy for budgeting as it contains the business's weekly, monthly, and yearly sales, income, and expenditure records. These records will help business owners create accurate budgets to aid their loan decisions based on the historical performance of their company.