Applying for a small business loan can be a strategic decision to help your business reach its long-term goals. It is tough to grow without access to capital, as often you have to make investments and purchases before you see the increased revenues that they will generate. Even businesses with strong cash flows borrow money because they understand that you need a business loan to grow.
The technical term for borrowing to support growth is “leverage” or “debt leverage.” It is a strategy where businesses use borrowed money to grow their assets, generate returns on capital, or increase an investment’s return. It also refers to the amount of debt you have on your balance sheet to finance your assets.
The time will come when you will need to borrow to grow. Still not convinced? Read on for many common reasons that businesses find themselves needing to borrow to grow.
Existing revenues often only support existing sales. The money and profit you make from selling current inventory may not be enough to purchase new stock and expand your product line. Or your café is always full, and you want to expand into the empty storefront next door to accommodate more customers. An opportunity arises to land a big client, but your current machinery does not have the production capacity. These are all reasons to borrow.
Borrowing capital allows you to make investments that drive growth, whether it is expansion, new or more inventory, or equipment purchases. It also lets you grow at a faster rate than if you waited until you had set aside enough money from current profits to fund growth. Infusing a large chunk of capital into your business at just the right time can skyrocket your business to the next level of sales and profits.
But debt must always be used responsibly. When borrowing, be aware that increasing your leverage ratio can make your investment riskier. If it does not generate the expected return, your loss will be greater.
If you are unsure if taking out a loan to fund these investments is a smart financial move, look at your debt to service coverage ratio (“DSCR”). This ratio measures your ability to repay a loan from existing revenues. To calculate DSCR, divide your net operating income by total debt service. Total debt service would be the monthly payments and fees.
If the ratio is over one, you can safely borrow. Be cautious and make sure that you can both afford your current debt service and the amount you would have to pay if you took out another loan.
While you might not be planning on growth or expansion, sometimes an opportunity appears. A customer places a large, unexpected order that would require you to buy more inventory than your cash on hand. A competitor goes out of business, and you have the chance to capture their customers or buy buildings and equipment at a significant discount. Even if your revenues could fund those purchases, what if your cash inflows don’t align with a fabulous market opportunity?
Savvy business people know that luck and timing can play a role in a business’ success. Letting an opportunity pass by may not hurt your business, but it could keep you from reaching the next level of success. When opportunities which make sense financially present themselves, it might be a good time to borrow.
When trying to decide whether a market opportunity is worthwhile, consider your return on investment (“ROI”). Return on investment is a percentage which expresses the amount of money that you’ll earn from the money you put into an investment. Calculate it by subtracting the cost of your investment from its gain and then dividing by the investment’s cost.
Average returns on investment, and what is considered a good return, vary by industry. Of course, you should have a positive ROI, but as a general rule of thumb, the return should also be better than what you could get in the stock market. And if the ROI is more than you would pay in interest, take out a business loan and jump on the opportunity.
Your small business might have started with a dream in your garage, but at some point, you cannot do it all. Outsourcing bookkeeping or other tasks frees up your time, hiring engineers or designers could help make your idea a reality, and an amazing salesperson will know how to sell it. However, you should only borrow to acquire talent if you can directly relate that person’s talent to the revenue that they will generate.
Hiring talent to fuel growth could be necessary for certain types of businesses and industries, particularly if the small business owner lacks a particular skill set.
No matter how wonderful your product, you have to sell it. Your new café could be the first vegetarian spot in town, but if no one knows that it exists your clientele will not find you. Marketing efforts increase awareness and spread the news of your product, business, or brand. And, if you’ve made a significant investment in a new product, you will need to market it to your target audience.
Marketing efforts can be as simple as taking out an advertisement in a local paper or as involved as attending a national tradeshow to present your invention. Whatever your business needs to do to market itself money will be involved.
Working capital keeps your business afloat. Whether it is through excess cash flows or a business line of credit, it funds your business’ day-to-day operations and helps you meet your obligations. If your business’ cash flows do not always align with its expenses, an open line of credit can help you smooth over cash flow issues. Draw on the line when you need to pay rent and pay it off once a customer has settled their payable.
With less worry about meeting their monthly obligations, a small business owner can focus more on growing their business. And, since they will be making all payments on time, it will help protect and build their credit in advance of the day when they need it for a larger, growth-oriented, investment.
In the beginning, with less time in business and perhaps less understanding of the loan’s impact on your cash flow, you might have taken out a loan which had less-than-favorable terms. The payments on your existing debt could hurt your ability to invest in growth plans. Interest rates could be lower now, and if your financial situation has improved a new business loan might come with better terms.
Taking out a small business loan to repay older debt can be a smart move for many small business owners. Lower rates and better terms lead to lower payments, which in turn frees up cash flow to help realize your long-term plans. It is not uncommon for companies to go through several rounds of capital while scaling up, and they often borrow the next round to pay off the last round when graduating to the next level.
Even if there is no business reason to take out a small business loan, there could be a strategic reason. Taking out a small loan and repaying it can help improve your credit score and establish more business credit. Credit scores are built by demonstrating that you can successfully manage and repay debt. If you have a low personal credit score and know that, at some point, your business plans will require access to more capital, a small loan responsibly managed now will set you up to borrow more later.
While you may balk at the thought of paying interest on money that you do not actually need, remember that interest payments on business debt are tax deductible. Check with your accountant, as there are limits to deductibility based upon business size. But for most small businesses the interest paid on a loan has favorable tax implications.
This will also help you establish a relationship with a lender. Banks and lenders prefer to lend to people with whom they already have a relationship. They will have easy access to your accounts, and can often link them for automatic payments. And if they know and have first-hand experience of your ability to manage funds, they will be more willing to lend in the future.
Small business loans serve various purposes in helping businesses succeed. Many successful business owners can attest to the idea that businesses need to utilize funding to grow their business.
