Much of how I feel about when and where to borrow I learned working with my Dad in his small business as a young man. My views are pretty conservative when you consider that popular media would have us all believe that money is the answer to every small business challenge. I just don’t believe that.
Creative problem-solving is the real answer to most of the small business challenges owners face—even in the current coronavirus-induced recession.
That said, I agree there are times when borrowed capital, leveraged as a tool, can be invaluable to business owners who are building a business. I’m convinced that borrowing to increase ROI (or profits), and borrowing to increase the value of a business are both legitimate, and smart, reasons to borrow and should be the yardstick used to measure every opportunity to seek a small business loan.
That’s not to say there aren’t other times when borrowing isn’t reasonable, but those times should be approached with caution. Regardless of where you borrow, there are costs associated with a loan that a business owner can’t afford to ignore. It’s even possible to borrow a business into a hole it can’t get out of by borrowing for the wrong reasons—or borrowing too much.
5 Questions to Ask Yourself Before Applying for a Loan
Once you’ve determined the addition of extra capital will provide value to your business, there are a handful of questions you should ask yourself before you approach a lender or complete an online application.
- What is my loan purpose? This is at the top of the list because it will help inform the rest of your answers. Are you borrowing to fill a short-term need like the purchase of quick-turnaround inventory at a discount, or are you borrowing for something more long-term like the purchase of equipment or real estate. If your answer doesn’t go beyond, “I need extra money,” it might not be a good reason.
- How much money do I need? Your answer to the first question will also inform this answer. When I speak with business owners I often ask this question. If they answer, “How much can I get?” I cringe. Borrowing more than what is really needed, simply because you can, burdens your business with an obligation that is hard to justify. I’ve witnessed many businesses over the years that borrowed their way into bankruptcy because the cash flow burden of the periodic payments was too great. How much money do you need? The amount required to meet the business objective, and no more.
- How much interest expense can I afford? This is another answer directly tied to your loan purpose. If borrowing to increase ROI or profits, for example, a good rule of thumb might be to leverage the borrowed capital to earn $3 or $4 dollars for every dollar borrowed. By incorporating the cost of financing into the cost of the project, you will be able to determine if borrowing makes sense; and what type of interest expense makes sense. Regardless of whether you’re meeting a long-term or a short-term need, considering the total cost of capital and what the potential return might be will help you determine if the expense is justified.
- Are my financial ducks in a row? Judging by the number of small business owners turned away from the Paycheck Protection Program (PPP) because they couldn’t verify their payroll or financial situation, it looks like there are far too many small businesses that need to get their financial house in order. I once spoke with a lender who said, “If I can tell more about a business’ financial health by looking at their financial reports than they can, I won’t offer them a loan.” Don’t let that be you. If you are unsure about what the financial reports are telling you, talk to your accountant or other trusted financial advisor to learn more about this important part of your business.
- Is my personal and business credit in order? If you don’t know, you should. As a business owner, your personal credit will always be part of any creditworthiness equation. And, combined with your business credit will have a direct impact on the options you have and how expensive those options are. Although there are no shortcuts to a strong credit profile, good credit practices over time will improve your situation and help you prepare to borrow down the road.
Fortunately, even in our post COVID-19 world there are lenders who want to lend and financing options available. Borrowers just need to be more savvy than ever before as they evaluate their situations, consider their loan options or loan alternatives, and decide whether or not borrowing makes sense for them.