Insights
Taking Out Multiple Loans: Risks and Alternatives to Increase Cash Flow
By Ellen Chang
Factors to consider when looking to take out more than one loan
When Bradley Zall began to expand his company three years ago, he needed a large infusion of capital to purchase inventory and equipment. The company he founded, Accurate Chemical, based in Tempe, Arizona, is a capital-intensive business. It serves the hospitality industry throughout the Southwest by manufacturing and distributing its own soaps, detergents and sanitation products.
“There was a disruption in the marketplace and to seize the opportunity, Accurate needed to invest a significant amount of money by putting in a commercial dishwasher that costs $4,000 to $10,000 each,” he said.
Although he has millions of dollars invested in these commercial dishwashers, commercial banks do not consider them as collateral since they’re an asset that would not be easy for them to repossess if his company failed.
Instead, Zall got an SBA loan from a local bank. This was in addition to the revolving line of credit he already had to help with the fluctuations of cash flow, as he had taken on over a dozen new employees and other operating expenses.
The following year, Zall was approved for an equipment term loan that was used to term out a portion of the bank’s existing revolving line of credit. He used the rest of the proceeds of the loan for operating expenses and to purchase more manufacturing equipment and dishwashers.
Having multiple loans was stressful, but after Zall shopped around, he was able to get all of them approved from the same bank, which made the process smoother.
“The best approach for a borrower who needs additional funding is to work with their original bank. Banks are not in the business to foreclose clients. As a client’s trusted business partner, we want to work with them to find solutions,” said Danny Chan, vice president and branch manager at East West Bank.
“It was easier to work with the same bank because they need to trust in you and understand your story,” Chan said. “Having a banker believe in you is equally as important as showing a strong profit and loss statement. A bank that understands your industry, the vision, and has confidence in you executing is as important as your balance sheet.”
“Having a banker believe in you is equally as important as showing a strong profit and loss statement. A bank that understands your industry, the vision, and has confidence in you executing is as important as your balance sheet.”
Accurate Chemical is now generating nearly $20 million in sales a year, and the business is profitable.
“The bank understood me, and they built a program to support my growth,” Zall said.
Companies that need additional cash flow by getting a second or third loan should approach the same lender, said Stuart Michelson, a finance professor at Stetson University in DeLand, Florida.
“Typically, multiple loans from different lenders is frowned upon,” he said.
When companies need additional lending, asking their current bank to consolidate or replace the original loan with a larger loan is another alternative, Michelson said.
“If the original lender is not interested, a firm can approach a new lender, requesting a loan large enough to replace the initial loan and also supply the additional capital required,” added Michelson.
SBA loans as an option
SBA loans are another option because they offer favorable terms. However, they can be highly competitive to obtain since their loans require the company’s assets to be offered as collateral. If the company’s assets are insufficient to fully secure the loan, liens on personal assets may be required, Michelson stated. It’s important to note that SBA loans cannot be used to pay off inadequately secured creditors.
“A firm will need to ensure all of the requirements are met to obtain an SBA loan, in addition to a conventional loan, which is not typically likely, unless the firm has enough assets and adequate cash flows to cover the additional loan,” Michelson said.
“A firm will need to ensure all of the requirements are met to obtain an SBA loan, in addition to a conventional loan, which is not typically likely, unless the firm has enough assets and adequate cash flows to cover the additional loan.”
One common loan is the SBA 504 loan, which provides financing to buy assets such as real estate at long-term, fixed-rate financing.
“The 504 loan is a good product,” said Chan. “The bank initially finances the entire property with a conventional loan (first 60 percent), plus a bridge loan (up to an additional 30 percent). The bridge loan is then paid off by an approved SBA 504 CDC (Certified Development Company) that will hold second lien while the bank continues to hold first lien.”
For equipment loans, Chan added that a better option would be the SBA’s 7(a) loan rather than a 504 loan. Because technology can become obsolete after seven to 10 years, the 504 loan‘s 25-year amortization could be “very risky,” he said. “A better fit would be SBA 7(a), which have maximum terms of 10 years, $5 million, and 10-15 percent minimum down.”
Chan talks more about how small businesses can benefit from an SBA loan here:
Companies that seek multiple loans need to ensure that each loan is used for its intended specific purpose.
“Getting multiple loans is definitely sanctioned,” Chan continued. “For example, a commercial and industrial revolving line of credit can only be used for working capital or trade financing. It cannot be used to purchase property or equipment.”
Companies are encouraged to seek out an additional loan from the same bank because that bank may be willing to lend more money by looping both loans together to maintain first position (via cross acceleration and cross collateral), Chan said.
“When a lender is in second position, they may loan less money to reduce their risk because they are at the mercy of what’s left over after paying off the first loan,” he added.
Alternatives to loans
Having more than one loan has many risks and could put a company’s future in jeopardy. Lines of credit, factoring, short-term loans, asset-based loans, or leasing instead of purchasing equipment are some legal alternatives to a company taking out multiple loans, said Michelson.
“When a firm has multiple loans, the initial loan may have covenants that restrict additional loans and specific financial ratios that must be met to remain in good standing with their lenders,” he said.
When a company fails to meet the financial ratios or takes on additional loans, the first loan will be in default and may become immediately due, putting the firm in a huge financial bind, said Michelson.
“Additionally, the payments due on multiple loans may put the firm in a cash flow crunch, making it difficult for the firm to fully make the payments due in a timely manner,” he added.
Quite often, the client needs to look internally to fix their cash flow issues, Chan said. “Maybe they expanded too fast, carried too much inventory, or their vendor terms were unfavorable,” explained Chan. “Maybe the machine they bought didn’t generate enough revenue to support it. Many clients think all they need is more money, but in reality, the money is in front of them if they are willing to let go and embrace change in the ever-changing business environment.”