Deciding when it is time for your small business to apply for business loans is as vital as deciding how much to apply for and where to get business loans from. Borrowing money might not be the best choice for you right now. How can you make sure that the loan is going to help your business succeed and not bog it down with a ball and chain of debt?
There are five points to consider when you are thinking about taking out a business loan. Evaluating these points carefully can help you make wise financial choices that will keep your business stable.
1. Establish vendor relationships.
Sometimes loans can be avoided if the primary purpose is to pay vendors while you are waiting for customers to pay you. Even if you still need to take out a loan, you may be able to take out a smaller one.
If your vendors require immediate payment but your terms with your customers is 30 days, offer your vendor a deal. Promise them that they will be your exclusive vendor if they will invoice you instead. This gives you 30 days to pay and you will likely have the payment from your customer in time to pay your vendor without the need to borrow money.
2. Evaluate loan types.
If you still need to borrow money, examine all various types of small business loans. The terms of the different kinds of loans is vital information that you must make sure you understand.
Don’t necessarily think in terms of one lump sum, either. Experts recommend clearly delineating what you need the money for, and then breaking those needs into short-term and long-term categories. Use a year as a benchmark. Things like inventory, which turns quickly, would be a short-term need. Equipment that will last awhile would be a long-term item.
Consider different loans for short and long term needs. Short term needs might best be served with a loan of less than a year. Longer term needs might need a longer loan period for a larger amount.
Interest rates vary from lender to lender, so look around to make sure you are getting the best interest rate possible.
3. Know how much you can realistically afford.
You want to make sure you can pay back what you have borrowed without placing an undue strain on your business. To do this, you need to calculate your debt coverage ratio. First, figure out how much money your business earns each month after expenses but before any sort of debt is paid. Divide this number by what you expect your debt payments to be each month. The ratio you get should be no lower than 1.25 and 1.50. Hopefully it will be higher.
For example, say your loan repayment will be around $900 a month. Your cash flow after you have paid expenses needs to be at least 1.5 times that payment. In this case, that’s $1350.00. Think carefully about whether you can afford that. You need to be sure you can repay the loan, even in a worst-case situation. If you can’t, then you need to rethink the amount you want to borrow.
4. Alternative Lenders
Since the recession, banks have restricted the amount of money they will lend to small businesses and tightened up on the requirements to get small business financing. Because of this, small businesses may look to alternative lenders. These are not banks or credit unions, but other institutions that offer cash advances, lines of credit, and loans.
There are pros and cons to going with an alternative lender. Their rates tend to be higher than the banks’ offerings because there is a higher risk involved. But they are also looser on their terms and often give answers within a week compared to the several weeks it may take a bank to review documentation and make a decision.
Banks demand copious amounts of intense paperwork, including tax histories, business plans, financial statements, collateral, and good credit scores. Alternative lenders might use different means to determine your eligibility. They might look at your social media presence or customer reviews on sites like Yelp. Loans may be based on your sales. Alternative lenders are quickly becoming a solid option for businesses that don’t want to go through a bank or wouldn’t be approved by one.
5. Calculating the Need
The key to responsible borrowing is making sure you have borrowed the amount you need and that you can pay it back. Don’t guesstimate an amount to ask for. Do some careful calculations. Decide what the money is needed for, and how much each line item will cost. If you are looking at equipment or using a contractor, get estimates. Don’t forget things like hiring, deposits, franchise fees, etc. If you are just starting out, detail all the expenses you might have before your doors are even open.
Plan a two year budget. Look at when your cash comes in versus when your bills are due. Examine any lag between when you provide your service or goods and when you actually get paid. Try to realistically predict the sales and expenses of the next 24 months and when they will occur. This way you will be able to borrow enough to see you through any cash-strapped periods.
Ideally you should have six months of capital available to guard against difficult times. But this is a rule of thumb. Your situation may be slightly different if your business is seasonal, for example. If you have been in business awhile, look at past times when the economy took a downturn. How much did your sales sink? How many months showed a loss? Can you withstand that now, or do you need to borrow to cover it? Looking at past trends can help you prepare for future ones.
Apply for funding soon after you determine that you really need it and are ready for it. It may take several months to actually get the loan, and you want to make sure you are prepared for future surprises in advance.