A self-liquidating loan is a type of loan used to finance assets. You repay the loan with the cash flow generated from the sale of the assets that were originally acquired by the loan.
Typically, self-liquidating loans have repayment schedules that are designed to coincide with the cash flow associated with the underlying assets. They tend to be short term and are most often used by businesses. Let’s examine how self-liquidating loans work, who may use them, and what their pros and cons are.
Definition and Examples of Self-Liquidating Loans
Self-liquidating loans are used to finance assets and are repaid using the cash flow generated by those assets. Typically, a self-liquidating loan is used to finance a temporary need for more assets that will generate cash flow. These types of loans are most commonly used in seasonal businesses where the majority of sales happen within a relatively short time period. Because self-liquidating loans fund temporary increases in the amount of assets, they tend to have a short repayment period.
L. Burke Files, President of Financial Examinations and Evaluations, Inc. in Tempe, Arizona, explained to The Balance via email that the term “self-liquidating loans” isn’t a formal financial term, but is a common way to refer to the arbitrage rates between money borrowed and money invested with matched maturities.
Files said that a self-liquidating loan is made to an enterprise and that it is paid off through either the sale of assets or a delta between the borrowing rate and the rate made on the money. He gave the example of how it may work with commodities.
“With commodities, a farmer may borrow $500,000 to harvest his grain and send his grain to a grain silo,” Files said. “The lender has a lien on the grain and as the gain is sold, the interest and principal of the loan are paid in full by the sale of the grain before the farmer receives any money. Thus, the loan self-liquidates through the sale of the grain.”
How Self-Liquidating Loans Work
Self-liquidating loans are what they sound like—loans that self-liquidate through the sale of an asset. For example, a seasonal business that sells summer clothing may do the majority of its sales during the spring and summer seasons. Because it doesn’t make very many sales in the fall or winter, when spring rolls around and the business needs to stock up on inventory, it may get a self-liquidating loan to purchase inventory to sell during that time period. Once the business sells off all that inventory during its peak season, it can use the resulting inflow of cash to pay off the loan in full.
With a self-liquidating loan, the surge in cash flow can be anticipated. Because of this, it’s likely that the loan terms won’t require a business to repay its self-liquidating loan until after its peak sales season is over.
Do I Need a Self-Liquidating Loan?
Self-liquidating loans are often used by companies that need to buy inventory, company treasury departments that borrow from banks, and organizations that buy funds and short-term financial products.
Businesses may find they need a self-liquidating loan to help cover expenses they know will generate money to repay the loan. For example, if you run a seasonal business such as a ski resort, you may need a self-liquidating loan at the beginning of the season to buy more gear to sell in the shop or to renovate hotel rooms to increase bookings. Once the resort has customers booking rooms and spending money in the shop, the self-liquidating loan can be paid back.
Alternatives to Self-Liquidating Loans
Files said there is risk associated with buying the assets to sell and repay the self-liquidating loan debt. “Do not take on borrowings where the risk of collection is too high or variable,” he said.
One option for avoiding a self-liquidating loan is to pursue a business line of credit. This form of borrowing may cost less than other financing methods, and allows you to draw funds from the line of credit as needed instead of borrowing a lump sum of cash.
A business credit card may also provide temporary financing if your business is confident it will be able to make its monthly payments. Business credit cards tend to have more straightforward application processes and qualification requirements than business lines of credit do. Plus, these cards often give you the chance to earn rewards for spending.
Pros and Cons of Self-Liquidating Loans
Straightforward borrowing solution
Risky depending on assets purchased
- Straightforward borrowing solution: Self-liquidating loans offer businesses a simple and smart structure to borrowing money. Use the loan to buy assets. Sell those assets. Use the money from the sales to repay the loan.
- Risky, depending on assets purchased: Businesses have to worry about the risk of the performance of the assets purchased because there is a chance they won’t make enough money to pay back the loan.
Are Self-Liquidating Loans Worth It?
Files said self-liquidating loans can be a very smart option, but that there are risks involved. “Again, look at the risk of payment to cover the debts,” he said.
Do your research, crunch the numbers, and weigh your options before choosing the right type of financing for your business.
A self-liquidating loan may be worth it if you’re confident your sales will be enough to repay the loan. However, you’ll need a backup plan in case those sales aren’t what you anticipated.
How To Get a Self-Liquidating Loan
To get a self-liquidating loan, you’ll need to work with lenders to design one that meets your financial needs. When creating this borrowing agreement, Files urged businesses to keep an eye on the fine print because “the devil is in the details,” he said.
- Self-liquidating loans are used to finance assets.
- The loan is repaid through the cash flow generated by the sale of those assets.
- Self-liquidating loans tend to have short repayment terms that coincide with the cash flow associated with the underlying asset.
- Not everyone will be able to utilize a self-liquidating loan. Seasonal businesses often use self-liquidating loans.
- Alternatives to this type of financing include business lines of credit and business credit cards.