As a business owner, you most certainly have goals you want your business to accomplish. And, many of these goals may require capital in order to be reached. You just may be considering a small business loan to help you pave the way.
But, before assuming a loan is the answer, you have to ask yourself “Is this the best plan for my business?”
So, how do you decide if you should take out a business loan? Come up with an answer to these two questions:
- Can You Afford It?
Debt can 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. Yikes.
You’re probably thinking it’s easier said than done to figure out if you can afford a loan, but here is an equation lenders will use to answer the same question. No reason you can’t use it too!
Start by taking the average amount of liquid cash you have on hand at the end of every month, and divide it by 1 and half. If that number is greater than what your potential monthly debt payment would be, it is safe to assume that you can afford those loan payments.
1 and a half is a typical debt service ratio that banks or other lenders use as proof you’ll be able to cover loan payments and still have cash left to run your business. Using a larger debt service ratio (greater than 1 and half) makes for an even more conservative estimate.
- Will it Help Your Business?
Even if you can confidently say you can afford a loan, you’re not there yet. It’s not just about whether you can handle it financially — it is about what this means for your business. Can you honestly say it will help your business?
Even if your small business loan is financially feasible, there are still some circumstances where taking on debt isn’t the best choice. To give you an idea, here are some good and bad examples of reasons for taking out a business loan:
If you’ve done your research and are confident that a new location for your business is the right move—but don’t have the capital to expand—a loan can be an advantageous solution. After all, the sales from this new location should presumably increase profits, giving a worthwhile return on your investment.
If you’re not certain if this is a smart move, start by comparing 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, than the loan will likely be a profitable choice in the long run.
Covering cash flow gaps
Sometimes delays in receivables just happen. Waiting for payment from one big client can be enough to create a temporary cash flow issue. Sometimes, when this happens, taking out a short term business loan is what you need to keep things running smoothly while you wait for payment. Keep in mind that you’re likely to lose profit due to the loan’s fees, so don’t make this a habit. Make sure your business has a specific policy in place for penalties on late payments to prevent this from happening again in the future.
Predictable marketing campaigns
Taking on a loan for marketing purposes is a little bit scary. But, if you have marketing campaigns that have 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 those campaigns, then it’s a smart decision. With a predictable result, you know how much debt (plus interest) you can take on for those marketing efforts and still retain a profit.
Buying something just for the discount
Who doesn’t love a good sale? Sometimes it can seem worthwhile to do whatever it takes to get a good deal—even on something unnecessary. 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. It may be best to let this sale slide.
The problem with taking on debt to pay bills is that it can begin or perpetuate a very dangerous debt cycle. Unless you’re specifically expecting an influx of cash—maybe because you’re also waiting to be paid by clients or have a seasonal business—taking on more debt doesn’t create a solution for the next time those bills come around. You’ll end up regretting how deep you’ve dug the debt hole.
Always think of any type of debt as an investment in your business. You only want financing options that offer positive ROI for your company. Ask yourself the questions above before committing, and you’ll be headed down the smart financing path.