A Business Loan Terms and Definitions Handy Guide

Side view of young businessman sitting on chair in interior with business sketch.

You might have come into contact with certain loan terms. That is if you ever tried obtaining an auto loan, student loan or a mortgage. But when you business loan shop, you need to understand business loan terms and definitions. Because this type of loan includes a lot of specialized languages, this is our topic today.

A business loan can contain collateral requirements. Because of this, avoid signing any document you do not completely understand. Most importantly, you need to understand the basics of business loans. Remember, you need to understand every word. Because you could be signing away your business if you default on the loan. Therefore, it is a good idea to keep a copy of this business loan terms and definitions guide with you. Especially while you read over the loan application and the loan documents.

Article Warning: This will not be the humor infused feature article to which you have become accustomed. This is a glossary.

Business Loan Terms and Definitions: Glossary of Terms

This mini-dictionary provides you a quick, efficient method of finding the term you need. It will help you understand it and its related or similar terms. Also, you can keep this open for finding terms using control plus “F”. Do this especially while you read the loan documents from your financial institution. These documents will include the information and documents you need to include with your loan application. Also, you’ll be given explanations of the terms used on applications and the terms used in loan documents. When it comes to your financial education, knowing this stuff is the basics. You simply cannot do anything in the bank or when communicating with the lender if you don’t know what they are talking about.

Because of this, it’s always important to get to know the basic terminology, whether you are getting a loan, a mortgage, a credit card, or something else. This is the only way to avoid being tricked into accepting something you would not normally accept. And by normally, I mean had you known what it actually means. So make sure you check your knowledge before entering any kind of financial talk. This blog encompasses all relevant business loan terms. Maybe you know some of them, so it’s great to revise. And maybe you’ll learn something new. I hope you will.

So, let’s jump right in and start because you definitely need to know this awesome stuff.

Financial Statement Terms

Firstly, when applying for a business loan, you will need to place with the loan application numerous supporting documents. As you maybe know, these documents include financial statements. These statements describe the current state of your business and forecast its potential. We’re not going to go into each individual document, what it shows and why the lender needs it. But we’ll try to cover as many terms as possible which you may come across when you start applying. Remember, the internet is full of useful information. Loanry is a credible source you can use to research various topics about business loans, so use it!

Assets and Balance Sheet

The first two terms we are going to discuss are assets and balance sheets. Assets are any item of value or ownership or interest in personal or real property. It can be leveraged as collateral for obtaining a loan or to pay off a debt. On the other hand, a balance sheet is a financial statement typically calculated monthly. It defines the assets, liabilities, equity and net worth of an organization as of a specific moment in time. You can see how relevant these are when you’re applying for a loan.

Business Plan

Secondly, we have a detailed document that defines your business framework, strategy, and development plan. These are typically professionally researched, written, printed and bound. The contents of this document include an executive summary, industry or sector overview and how your business fits within the sector. Also, it includes market analysis, competition analysis, your marketing plan including your Unique Selling Proposition, management plan including your specific legal structure.

Moreover, it consists of a complete accounting of management resources, operating plan, financial plan with detailed financial statements, balance sheet, income statement. Also, it includes the cash flow statement or cash flow projection if yours is a new business. The business plan’s appendices and exhibits include marketing studies, product photographs or mockups and relevant legal documents. Businesses often hire a consultant to lead the research and development of a business plan.

While we’re here, let me just take a short detour. A business plan is something you should definitely have, regardless of whether you’re planning to get a business loan or not. This is literally your way to success. Without a carefully constructed plan to guide you as a new entrepreneur, you have no chance. I mean, maybe you do, but it’s much slimmer. A business plan means that you invested time in the route which you are going to take so you would succeed. And lenders like to see that.

Business Revenues

Thirdly, we have business revenues. This is the amount of money a business receives in a definite time period such as the first quarter. This figure includes deductions for returned merchandise and discounts. Your business revenue, also called gross income, is the figure you subtracted from when calculating net income. When you apply for a loan, the financial institution will require full disclosure of the business revenue, typically for the past three years, and your Debt Service Coverage Ratio (DSCR). You do not have this information when founding a new business, so you forecast projections based on anticipated product sales.

Capacity

Onto the next one: capacity. This refers to the repayment ability of an organization. Part of a loan application consists of the capacity documentation which includes a repayment schedule accompanied by an explanation of the sources of the repayment funds. An organization’s capacity includes its revenues, expenses, credit history, cash flow and timing of cash flow.

Capital

This term refers to the cash, assets and the organization utilized in transacting its business; also, the owner’s investment in the organization. The loan officer will consider both the capital’s amount and quality.

Collateral

The next term we’re going to talk about is collateral. This refers to the sum total of assets personally owned by the applicant that will be offered as loan security. Banks require collateral, but alternative lending platforms typically require little to no collateral. Therefore, you must provide documentation of your collateral.

Current Ratio

Next we have the current ratio. This is a measure of liquidity calculated by dividing the current assets by the current liabilities. The greater the ratio, the more significant the cushion between an organization’s current obligations and the organization’s ability to meet them.

Equity and Equity Participation

The next two terms are equity and equity participation. Equity refers to the value of an organization’s property greater than the total debt held on it. This can be an owner’s share or percentage of a business that earns them a return of the profits. This type of investment carries a greater risk than a loan, but also provides greater returns, if successful. On the other hand, equity participation refers to an owner of an organization or partner in a business venture. Importantly, the equity participant provides an investment in exchange for a potential return on investment (ROI). ROI depends on how profitable the organization becomes.

Fund Balance and Limited Recourse

The next two are pretty short and easy to remember. On one hand there is fund balance. This refers to a calculation of total assets minus total liabilities. Also called net worth in a nonprofit organization. On the other, we have limited recourse which are rights only to specifically stipulated assets to satisfy an unpaid debt.

Loss Reserves

Next, are loss reserves. This is a permanent capital or a part of the fund’s earnings that the board of directors has designated as a reserve against a potential loan loss. The loan reserve remains unavailable for lending purposes. Loan loss expense must be reflected as an annual expense deduction on an accrual basis. The loan loss reserve is shown as a contra asset that reduces loan assets. On a balance sheet, the loan loss reserve is shown as a loan portfolio deduction.

Net Working Capital and Net Worth

Finally, we have two terms that are known to you. Net working capital in business refers to a calculation including in the loan application of current assets minus current liabilities. Lastly, when it comes to financial statement terms is net worth. This refers to a calculation achieved by subtracting the total liabilities from the total assets. The aggregate net value of the organization. This is called fund balance in a non-profit organization

Business Loan Terms and Definitions: Real Estate Terms

In business, real estate loans have a few terms of their own. These apply to types of business loans offered only in this specific industry.

Firstly, there is a bridge loan is a short-term loan generally used in real estate that provides temporary financing until the buyer obtains permanent financing. Another important term is interim financing. Similar to a bridge loan, this provides a short-term loan to in effect until the debtor obtains permanent financing

General Business Loan Terms

Some business loan terms do spill over into other types of loans. And ome you will hear in investment circles or in discussions of economic theory and practice. Let’s cover those as well, so you have a complete glossary of all the basic terms you could come across.

Bad Debt, Capitalization, Capital Markets, and Cash Flow Financing

  • Bad Debt. A debt the creditor cannot collect which becomes worthless
  • Capitalization. A term used in long-term debt which refers to the amount borrowed, what is repayable to third parties and the permanent capital
  • Capital Markets. Those financial markets, including institutions and individuals, that exchange security, especially long-term debt instruments
  • Cash Flow Financing. A short-term financing option to cover cash shortfalls when revenue is forthcoming such as payment of receivables

Conditions

Refers to an economic climate term that encompasses externalities such as general economic particulars. And the financial situation of the lending institution and the borrower. The term also includes reference to the loan’s purpose. So when filing the loan application, the applicant must include details on the money’s use. I’m going to quickly mention something that’s maybe obvious. You can always ask about any terminology that you may not understand clearly. Or you can go online (like you’re doing right now) and research yourself. Just don’t let it go and hope for the bast.

Covenant

A formal agreement or contract that agrees to do or not do a set of items. It can be a part of a deed. The covenant includes full disclosure, preservation of net worth, asset quality maintenance, adequate cash flow maintenance, control of management. Also, it includes control of growth, assurance of legal existence and concept of going concern and provision for lender profit or program goals.

Credit Score

Refers to the business’ FICO score. Yes, businesses have them, too. There are several kinds of business loans. But for all of them, this remains the single most important factor when attempting to obtain a business loan. When looking for a loan to establish a business, the applicant must use their personal FICO score to obtain the loan. This applies to both bank loans and Small Business Administration loans.

Current Asset and Current Liability

  • Asset. An asset that typically converts to cash within a year
  • Liability. Liability that will normally be repaid within a year

Debt, Debt Service, Debt Service Coverage Ratio, Debt Service Reserve

  • Debt. The amount owed on a loan. This includes the loan amount and its interest. Plus fees that are secured by a bond, note, mortgage or another instrument. The note includes the repayment and interest provisions
  • Debt Service. Refers to the regular due payment required to meet the debt agreement. It typically comes due on a monthly, quarterly or annual basis
  • Debt Service Coverage Ratio. Refers to your debt relative to your income. Banks prefer a DSCR of 1.25 or greater
  • Debt Service Reserve. Refers to cash reserves the borrower sets aside to repay the debt in case the business operations generate insufficient funds. This may be required by the covenant

Default, Delinquent, and Due Diligence

  • Default. Refers to a failure to repay the loan or comply with the covenants
  • Delinquent. This refers to late, overdue, past due or unpaid bill or loan
  • Due Diligence. Refers to the practice of fact-checking the materials and critical assumptions the borrower presents. It includes confirming the accuracy of financial statements, verifying income sources, the value of collateral assets, borrower tax status and other material facts

Endowment or Trust, General Recourse, and Guaranteed Loan

  • Endowment or Trust. A fund containing assets that earn income and restricting income withdrawn from the fund to that earned by the assets
  • General Recourse. Lender’s right to demand payment from the debtor, accessing their general assets without seniority in access to specific assets
  • Guaranteed Loan. Refers to a third-party’s pledge to cover the debt payments. Or perform an obligation if the debtor fails to make payment

Intermediaries

Refers to institutions with special lending capacities that obtain capital through equity and low-interest loans. They typically obtain capital from other funders such as foundations. This creates a lending pool from which the intermediary processes many small loans or investments. This includes some banks, credit unions, loan funds, and venture capitalists. Don’t let the fancy terminology scare you or confuse you. By now you saw that almost all terms have pretty simple explanations.

Lender-Agnostic Market and Leverage

  • Lender-Agnostic Market. Refers to brokers or loan marketplaces that connect borrowers with alternative and traditional lenders.
  • Leverage. Refers to the practice of utilizing long-term debt to secure organizational funds. It can also refer to financial participation by other sources in social investment.

Liabilities

  • Total Liabilities. The total value of financial claims on a firm’s assets. Equals total assets minus net worth
  • Limited Liability. Limitation of shareholders’ losses to the amount invested

Line of Credit, Linked Deposit, and Loan Agreement

  • Line of Credit. Agreement by a bank that a company may borrow at any time up to an established limit.
  • Linked Deposit. A deposit in an account with a financial institution to induce that institution’s support for one or more projects. By accruing no interest or low interest on its deposit, a foundation subsidizes the interest rate of the project borrowers.
  • Loan Agreement. A written contract between a lender and a borrower that sets out the rights and obligations of each party.

Market Rate, Negative Covenants, and Opportunity Cost

  • Market Rate. The interest rate at which a company receives its loan funds. Businesses can receive a zero-interest rate or below market rate interest rate on program-related investments.
  • Negative Covenants. Refers to an agreement or contract that stipulates actions or events the borrower must prevent.
  • Opportunity Cost. This refers to an economic principle related to the Pareto optimal. It describes the missed potential benefit from not following the financially optimal methods.

Personal Guarantee

You probably know this term from auto loans or student loans. It refers to a document that the borrower signs stating a legal promise to re-pay. In a business loan, this guarantee typically includes specific methods including liquidating collateral to pay the remaining balance. As you can see, there are some terms which appear in different context. Make sure you pay attention to these. And even if you are absolutely sure you know a term because of your past experience, it isn’t a bad idea to double-check the meaning in the context of business loans. Moreover, you maybe learn something new. And you also may save yourself from making a huge mistake.

Portfolio

This refers to an investment term describing the total sum of assets held by an individual or group. This includes those that provide both financial and non-financial returns. Typically, a portfolio includes a variety of assets vis a vis type and size. They are referred to as the asset mix or portfolio balance which maintains an appropriate risk and return level.

Principal and Program-Related Enterprise

  • Principal. Refers to the amount of the loan. Importantly, you pay interest based upon the principle of the loan
  • Program-Related Enterprise. A revenue-generating enterprise that promotes the organization’s social purpose goals. It can be a product or a service that charges a range of prices from fee-for-service to a full-scale commercial venture

Program-Related Investment, Promissory Note, and Receivables

  • Program-Related Investment. Refers to a fiscal term including all asset purchases, conversion of asset(s) to charitable use, equity investments. Also, it includes linked deposits, loans, loan guarantees, and some recoverable grants.
  • Promissory Note. Similar to the personal guarantee, the promissory note is a legal document which the borrower and the lender sign
  • . In this note, the borrower promises to repay the loan. And that provides an evidentiary document of the borrower’s indebtedness
  • Receivables. It refers to the accounts receivable of an organization which refers to the amount owed to the business typically due to an extension of credit

In Conclusion

You probably did not guess that borrowing money for your business would use so many different business loan terms and definitions. If all your loan experience consists of auto loans or educational loans, you probably had a few surprises. However, you now know many of the terms specific to business loans which can help you in business loan shopping. As with any part of your finances, you need to be up to date. It’s important that you understand everything about loans, credit cards, mortgages when you read about them.

Without proper education, you will not be able to understand your rights and your obligations. You’ll certainly get into financial troubles if you don’t understand terminology and definitions. New ones pop up every day as the lending community changes and grow. As recently as two decades ago, there was no online banking. But today, we bank online and apply for loans on the Web. Check back with us here at Loanry. You’ll learn new business loan terms and definitions as online banking and investing develop. And you can also find a lender who may give you a loan.