The growth and survival of small businesses largely depend on whether or not they have access to credit. Traditionally, small businesses could only turn to banks for their funding needs. Today, however, the narrative is different.
The emergence of the online lending market has seen many businesses turn to non-institutional lenders owing to the flexibility of their lending terms. The amount of small business loans taken out by US-based companies totals a whopping $599 billion.
From this number, it’s clear as day that without a small business loan, your company will have a hard time playing catch-up with the competition. If you’re looking for loan tips, you’ve come to the right place.
This small business loan guide explores 5 important things you need to consider before applying for credit financing. Read on.
1. Does Your Company Really Need a Small Business Loan
The first thing you need to think about before you take out a business loan is why your business needs the money in the first place. It’s a huge financial decision which if not considered carefully, can have far-reaching repercussions on both you and your business.
Borrowing money to pay for overhead costs like rent for your business premises, utility bills, and janitorial services is financial suicide. You’re setting yourself up for failure. Some of the reasons why your business would need a loan include:
Expansion
This is perhaps the most common reason why small business owners take out loans for their business. If your business gets an expansion opportunity, you might need to inject additional funds to make it happen. If the failure to expand leads to a stagnation of your profits or causes your profit margin to shrink, you need to get a loan to support growth.
Additionally, if your business needs to acquire new property or renovate the existing space, such an undertaking might be impossible to achieve if you don’t have the financial muscle to spearhead the process. Taking out cash from the business isn’t a realistic alternative if you intend to remain operational.
A business loan will facilitate this without running the risk of your projects eating into operational funds. What’s more, you might want to expand your business through marketing and advertising campaigns.
To enter new market segments you have to increase the exposure of your brand. This is only possible through a business loan.
Inventory
The growth of your business takes on many forms. One of these has to do with inventory.
Inventory is often one of the most challenging aspects of running a successful business in a myriad of industries. You have to strike a balance between having the right amount of stock and offsetting these costs when customers purchase the products.
As your business grows you have to continuously replenish your inventory to meet the growing demands of your customers. This becomes especially difficult to manage if you carry seasonal products and you end up with a surge in demand. During periods like these, taking out an inventory loan helps you keep up with growing demand and industry trends without negatively affecting your cash flow.
Cash Flow
Speaking of cash flow, this can pose a problem when you’re dealing with errant customers who habitually delay with payments or fail to pay for products/services altogether. Factoring in this alongside your regular business costs like utilities, rent, staff salaries and personal expenses like mortgage payments is enough to take the wind out of your sails.
A small business loan will suffice to cater to your regular operational costs and help your business remain afloat when funds are tight. Keeping the money flowing through your business allows you to continue generating revenue as you expand your customer base. This acts as a buffer while you sort out all the background issues constraining the flow of cash in your business.
Equipment
Some businesses require physical equipment which is paramount to the running of the business. For instance, if you own a gym, treadmills, stationary bikes, and elliptical machines are all part and parcel of the normal day-to-day operations.
The fact of the matter is that equipment costs money. Keeping them functioning costs even more money. But, you have no alternative because their breakdown will hurt your business’ bottom line.
Dealing with unplanned expenses such as the replacement or repair of broken equipment can cause your business to hemorrhage money. Taking out a small business loan to will give you a soft landing.
It’ll prevent you from breaking your budget by managing the costs associated with repairing or replacing expensive equipment. On the flip side, you might need to acquire a brand new piece of machinery to keep up with the latest trends in technology. Equipment financing will help you do just that.
Improve the Lending Terms of a Larger Loan
You have to be smart when running your business if you hope to stay afloat. One of the ways you can do this is by laying down the groundwork necessary to make your business eligible for a larger loan in the future.
The best strategy you can use is to get a small loan for your business that you’ll find easy to pay-off. The terms of this loan might not be favorable but you can think of it as a business investment.
Once you pay it off, take out another loan and repeat the process. The whole point is to build credit for your business.
That way when you eventually need to make a big purchase, you have access to a lump sum amount that can finance it. This is one of the best loaning tips you can apply if you have a small business in its infancy stages.
2. What’s the Most Appropriate Amount to Borrow
Once you identify why you need to take out a loan, the next step is to think about the amount of money you can realistically afford to pay back. The word “afford” here goes beyond your ability to be able to cover the monthly installments. There are two primary methods you can use to determine whether or not you can afford to take out a business loan.
Debt Service Coverage Ratio
The Debt Service Coverage Ratio (DSCR) is simply the percentage of cash that a business channels towards servicing debt. This includes paying the loan principal amount due, the total interest and all fees.
The ideal scenario is to have a DSCR that’s greater than one. This sends positive signals to the lender as well as the business that the company has enough income to pay off its debt obligations. The DSCR can be obtained using either of the following formulas:
- (Annual Operating Income (Net) + Depreciation Charges) / (Total Interest + the Present Value of Long-Term Debt)
- (Gross Income) / (Total Interest + the Present Value of Long-Term Debt)
Gross Income is the business’ total earnings before interest, taxes amortization, and depreciation. When you insert your business’ variables into the DSCR equation and end up with a ratio that’s less than one, it’s an indication that you need to reduce the amount you intend to borrow. Mastering this concept will guide you on how to take out a small business loan responsibly.
Loan Performance Analysis
Before you take out a loan for your small business, you’ll want to see whether the loan will have a positive or negative impact on the growth of your business. Will it give you a significant return on investment?
In order to determine this, the loan performance analysis looks at the cost of financing and compares this against your current revenues, projected revenues, and net profit/loss. It’s the crystal ball into the future of your business before you take the leap.
3. What’s Your Business’ Credit History
Now that you’ve figured out what loan amount your business can afford to borrow and pay back, you now need to determine what type of business loan you qualify for and what APR will be applied. The credit score of your business is the determining factor.
The million dollar question is, how great does your credit need to be to qualify for a business loan? Business credit scores range between 0 and 100.
Anything above 75 is considered “good”. Some of the elements that go into building your business credit profile include:
- Bill payment frequency
- Credit history
- Debt-utilization ratio
There’s technically no minimum credit score that would make your business ineligible for a loan. Lenders evaluate every business loan application on a case-by-case basis.
When lenders evaluate the risk associated with a particular business loan, they also like to consider the individual’s level of personal financial responsibility. So, they look at your personal credit score.
If you can’t pay your personal debts on time or have a default history, these tell the lender that your business loans share the same risk. If your personal credit history reflects a clean track-record, chances are, your business loan history will reflect the same.
Clean track-record here means that it’s free of bankruptcies, tax liens, and judgments. So they’re more likely to approve your business loan.
4. What Are the Terms of the Business Loan
Before you sign on the dotted line, you need to make sure that you understand all the terms of the business loan. Here are some of the common ones:
Loan Origination Fee
The loan origination fee, which is sometimes called the loan processing fee is the amount charged by the lender to facilitate the paperwork involved with your application. The amount could be expressed as a flat fee like $400 or as a percentage of the business loan amount.
Origination fees for first-time borrows are usually higher than for successive borrowers. The size of the origination fees also depends on the type of business loan you’re applying for. Short-term business loans, for instance, have higher origination fees than medium to long-term business loans.
The APR
When settling for a particular small business loan, getting the one with the lowest monthly repayment amount doesn’t cut. You need to consider what the annual cost of the debt will be.
The Annual Percentage Rate (APR) represents the true cost of the loan. This amount comprises all the fees and charges associated with the loan.
Hidden Fees
You’ll also need to consider the hidden fees associated with the loan. Is there a charge when you make a late payment? Will the lender penalize you if you pay off the loan early?
How much is the failed payment fee? You need to ask all these questions before you settle on a business loan from a particular lender. Make sure you review the loan documentation with a fine tooth-comb so that you’re fully aware of what you’re getting into.
5. What Is the Repayment Length of the Business Loan
The final thing you need to think about is what repayment length you’ll need for your small business loan. Different types of loans have different repayment periods associated with them.
A business term loan, for instance, has a repayment-duration of 24 months. Accounts receivable credit lines can either be, short or medium term.
This means terms may vary from six months to three years. So depending on the type of business loan you need and the loan period you want, find an online lender that can meet your needs.
The Bottom Line
Taking out a small business loan can be a double-edged sword. If used smartly, it can be a great asset for funding business growth.
If not, the consequences could end up crippling your business. Use the small business loan tips discussed in this guide to help you make the best decision.
Does your business need an easy business loan? Apply for one now.