As an entrepreneur, you have big dreams to grow your small business. You have a vision--an idea--and you want to turn that idea into action. But growing a business takes time, and it takes money. If you don't have the capital readily available to make your dream come true, you may be considering a small business loan to help you pave the way.
Dreams are the things that drive great, innovative businesses. But while you're dreaming, it's also important to take stock and give yourself a reality check. Is taking on a loan really the best plan for your business?
Before you sign on for a small business loan, you want to consider both the loan's feasibility and its purpose. To do this, you want to ask yourself two big questions. Can you afford this loan? And will taking out the loan be beneficial for your business in the long run? Let's consider both factors:
The Cash Flow Question: Can I afford this loan?
Smart use of debt can be great for growing a small business, but it can also be very dangerous if you don't have an appropriate repayment plan. In fact, according to the Small Business Administration, poor credit management is among the most common reasons that small businesses fail.
If you're not sure how to determine the feasibility of your loan, here is a common equation that creditors and entrepreneurs alike use to determine the affordability of a business's monthly loan payments:
Take the average amount of liquid cash you have on hand at the end of every month, and divide it by 1.5. If that number is greater than your monthly debt payment, you can safely assume that you'll be able to make your loan payments each month.
The 1.5 figure is a typical debt service ratio that banks often use as evidence that you'll be able to cover monthly payments and still have some cash left over to put back into your business. You can also use a larger debt service ratio (greater than 1.5) for an even more conservative estimate.
The Cost-Benefit Question: Is taking out a loan worthwhile for my business?
Once you've determined that you can afford a loan, there are still additional questions to be asked. Is taking out this loan going to advance your business? Will using loan capital directly increase revenue?
Even if your small business loan looks feasible on paper, there are still some circumstances in which taking on additional debt isn't necessarily the best choice. Here are some good and bad reasons for taking out a business loan:
GOOD REASON: Expanding to a new location
If you've done your research and are confident that a new location for your retail business would be successful--but don't have the available capital to expand--a business loan can be an advantageous solution. After all, the additional sales from your new location should presumably increase your profits, giving a worthwhile return on your investment.
On the fence about taking out a loan? Compare your monthly sales forecast for the new location to your monthly loan payment. If your minimum expected monthly profit is equal to or greater than the loan payment, the loan is likely to be a profitable choice in the long run.
BAD REASON: Buying something you don't need at a discount
We all love a good sale, and sometimes it can seem worthwhile to do whatever is necessary to get a good deal--even on something unnecessary for your business. Using a loan to purchase inventory or new equipment that will directly benefit your business revenue may be worthwhile-- but if you can't find a direct link between making the purchase and increasing sales for your business, it's probably not a good investment.
GOOD REASON: Consolidating high-interest debt
If you're faced with paying multiple high-interest loans, a business debt consolidation loan can often help to reduce the amount of creditors you're dealing with and lower your monthly debt payments, improving your overall cash flow. However, keep in mind that consolidating debt is only worthwhile if you can do so at an interest rate lesser than or equal to the average interest rate of your current outstanding debt.
BAD REASON: Paying off another loan with an equal or lower interest rate
Before you start shuffling debt, make sure you're actually getting a good deal. You might think a new loan makes sense upfront if the monthly payment is lower, only to find that you're actually paying a higher interest rate over the life of the loan. So remember to think long-term and compare interest rates so that in the end, you're saving yourself money over the life of your business.
GOOD REASON: Covering a gap in cash flow before you're paid by clients
Depending on the nature of your business, sometimes delays in receivables just happen. Waiting for payment from one big client can be enough to create a temporary cash flow issue. Occasionally, when this happens, taking out a short term business loan can be a reasonable solution to keep everything running smoothly while you wait to be paid. But you're likely to lose profit due to interest on the loan, so make sure your business has a specific policy in place for penalties on late payments--both to soften the blow on lost profit and to discourage repeat offenders.
BAD REASON: Paying overdue bills
The problem with taking on debt to pay overdue bills is that it can begin or perpetuate a dangerous debt cycle. Unless you're specifically expecting an influx of cash flow--because you're waiting to be paid by clients or have a seasonal business, for example--taking on more debt doesn't create a solution for the next time those bills come around.
GOOD REASON: Marketing efforts with a known expectation of result
The saying goes, it takes money to make money. Nowhere is this truer than in marketing, where often a significant investment is needed with a rather uncertain rate of return. A good rule of thumb here is only to use debt for marketing with a known expectation of result, meaning that you can measure--either from past experience or some type of forecasting--how much you can expect revenue to increase as a result of your marketing campaign. That will help you decide how much debt (plus interest) you can take on for the marketing effort and still retain a profit.
As an entrepreneur, it's important to think of any type of debt as an investment in your business. Not only should that investment be financially feasible, but it should have a reasonable expectation of positive return. Only those financing options which offer positive ROI will benefit the long-term health of your company. So take the time to ask yourself the tough questions as you consider whether your business has any business taking on debt.