- 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 short-term loans provided by banks to help your company meet its financial needs. Interest is charged on the outstanding amount, and you are required to repay the loan within a specified timeframe.
Typically, when you take out a bank loan, you are required to provide collateral—such as equipment or property. If you fail to repay the loan, the pledged asset is seized and handed over to the lender to recover the losses.
How do bank loans work?
Applying for a commercial loan typically begins with filling out an application form and submitting necessary documents, such as the company’s certificate of incorporation and financial reports.
Once all required documents are received, the lender analyzes your company’s creditworthiness and considers various factors before deciding whether to grant the loan.
These factors include your business’s financial statements (such as cash flow), your business plan, and the asset coverage ratio.
If your loan application is approved, the lender disburses the funds, which must be repaid at a fixed interest rate.
In most cases, you will also need tangible assets to secure the loan. If you fail to repay the loan, these assets may be seized to recover the outstanding amount.
Banks have played a pivotal role in financing traditional businesses.
However, bank loans may not be suitable for modern, fast-growing, and innovative online businesses. This is because such businesses often have fewer assets available for collateral and may present a higher risk-return profile.
Due to these characteristics, obtaining a loan through traditional bank credit assessment methods can be challenging for them. Insufficient financial statements can also act as a hurdle in securing a bank loan.
Read More: How Credit Scores Affect Loan Approval and Interest Rates
Pros and cons of bank loans
| Advantages | Explanation |
| Clear loan terms | Interest rates and repayment amounts are determined upfront, making it easier to plan a budget and estimate expenses. |
| No equity dilution | Bank lenders do not hold an ownership stake in your company. |
| Relatively low interest rates | Interest rates on bank loans are generally lower compared to other financing methods (such as inventory and invoice financing). |
| Disadvantages | Explanation |
| Complicated application procedures | Applying for a bank loan involves gathering and submitting a large number of documents. This process can be tedious and time-consuming. |
| Long turnaround time | The loan approval process can take several months. |
| Collateral required | E-commerce companies may not have sufficient tangible assets to offer as collateral. In such situations, banks might stipulate that the loan be secured against your personal assets. |
| Difficult to qualify | Some banks stipulate that, to be eligible for a loan, a business must have been operational for a certain period (such as two years or more). Passing the credit assessment is not easy. |
| Rigid repayment schedule | It is essential to repay the loan on time. In the event of a loan default, the pledged asset may be confiscated. This will also impact your credit score, potentially making it difficult to obtain loans from financial institutions in the future. |
| Interests on outstanding balance | Interest is charged on the unpaid amount. If you fall behind on loan repayments, the cost of the loan can increase. |
| Restrictive covenants | There may be certain restrictions on the use of borrowed money. |
Alternative to bank loans: revenue-based financing
In recent times, RBF—or revenue-based funding—has gained significant popularity among small and medium-sized enterprises (SMEs), entrepreneurs, startups, and e-commerce firms.
Revenue-based financing serves as a viable alternative to traditional bank loans, where businesses receive funding based on their revenue (earnings).
When you apply for revenue-based financing, your business undergoes a risk assessment.
If you qualify for the financing, the funds are disbursed within 48 hours.
Unlike traditional bank borrowing—which typically requires fixed, regular repayments—revenue-based financing offers the flexibility to make payments according to your revenue flow.
Under the RBF model, the financing platform collects only a small percentage of your monthly revenue to recoup the capital provided.
If earnings are lower in a particular month, your repayment amount decreases; conversely, if the month is profitable, you can pay more.
Ultimately, the total repayment amount is predetermined, typically comprising the principal capital and the associated cost of financing.
Pros and cons of borrowing money via revenue-based financing
| Advantages | Explanation |
| Flexible repayment | The repayment amount is directly linked to revenue. There is no pressure to keep paying loan installments. |
| No interest on outstanding balance | The repayment limit is restricted to the principal amount and a fixed fee. |
| No collateral required | This makes it easier for asset-light e-commerce companies to raise capital. |
| No restrictive covenants | There are no restrictions on how you use RBF funding. |
| Streamlined application process | Applying is quick and easy. For instance, Choco Up’s data integration system aids in risk analysis, allowing eligible applicants to receive an initial offer in just 10–15 minutes. If everything goes smoothly, funding can be secured within 48 hours. |
| No equity dilution | RBF platforms do not take equity or a board seat in your company. |
| Disadvantages | Explanation |
| Pre-revenue companies may not be eligible | Both funding and its repayment depend on your company’s monthly revenue. If revenue is very low or non-existent, securing RBF funding can be difficult. |
Should you consider bank loans or revenue-based financing?
Just as every individual is unique, no two businesses are alike. Long-term loans might be suitable for one organization due to their predictability and security, whereas another business might find Revenue-Based Financing (RBF) preferable because of its flexibility.
Each option comes with its own set of advantages and disadvantages. It is the responsibility of a company’s top management to evaluate all available options and select the one that best aligns with their specific needs.
There is no single “best” financing option for a business; the best choice is simply the one that most effectively meets the business’s requirements.
To help you select the ideal business financing option, Choco Up has prepared tables comparing various types of financing, such as revenue-based loans and bank loans.
|
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 |
Frequently Asked Questions
Ques. What is a bank loan and how does it work?
Ans. A bank loan is a sum of money borrowed from a bank that must be repaid over a fixed period with interest. Borrowers make regular monthly payments until the loan is fully repaid.
Ques. What are the main benefits of taking a bank loan?
Ans. Bank loans offer access to funds for personal or business needs, competitive interest rates, flexible repayment options, and can help build your credit history when repaid on time.
Ques. What are the risks of taking a bank loan?
Ans. The biggest risks include interest costs, late payment penalties, damage to your credit score if you miss payments, and the possibility of losing collateral for secured loans.
Ques. How can I increase my chances of getting a bank loan approved?
Ans. Maintain a good credit score, provide accurate financial documents, keep your debt-to-income ratio low, and choose a loan amount that matches your repayment capacity.