When should you get a business loan or financing
Wed | June 2023
Are you considering a business loan or some kind of business financing? Or you're unsure whether your business is even ready? Many small business owners grapple with these questions, so we put together this guide.
Our aim? To shed light on what you need to consider before taking out a business loan and to arm you with the knowledge you need to make the best decision.
This comprehensive guide contains actionable insights, examples, and resources. Let's navigate the world of business loans together.
Understanding good and bad business debt
To make sound financial decisions for your business, you need a clear grasp of what constitutes 'good' and 'bad' debt. Knowing that can set you up for success or failure; the difference isn't always black and white.
Good business debt
Good debt is a powerful tool in the right hands. It’s like a lever that can lift your small business to new heights. Seen as an investment in the future, good debt gives you the financial power to catalyze growth and success. Here's a deeper dive into the potential uses for good debt:
Expansion: Have you identified a profitable opportunity to expand your business? A second location or a new market segment? That’s where good debt comes in handy. It provides the financial means to seize growth opportunities and build new profit streams.
Infrastructure Improvements: Upgrades to your infrastructure – more extensive facilities or improved supply chains – can improve productivity and your bottom line. They may require a significant upfront investment, but they're the kind of expenditures that good debt can help facilitate.
Essential Equipment: You should purchase new machinery or equipment that boosts your production capacity or quality. A good debt loan can help you acquire these assets and drive your business forward.
Investing in Technology: The right tech can dramatically improve efficiency and customer satisfaction. Whether it's a state-of-the-art POS system, new manufacturing software, or a data analytics tool, technology often requires an upfront investment that good debt can cover. Read our guide on how AI can boost your business efficiency.
ROI-Driven Activities: Not all investments are tangible. You should engage in an aggressive marketing campaign or employee training. If these activities provide a positive return on investment, good debt can fuel them.
Bad business debt
Conversely, bad debt is a pothole on your business' road to success. Rather than fostering growth, it hinders your financial health. Let's look at a few common examples of bad debt:
Non-Productive Expenses: If you're borrowing to cover non-essential expenses or splurge on luxury items that don't contribute to your business's profitability or operational efficiency, you're stepping into bad debt. Whether it's an unnecessary office renovation or a company car that's more of a status symbol than a need, such expenses add to your liabilities without improving your asset base.
Speculative Ventures: Investing in high-risk, uncertain ventures can lead to bad debt. If you're borrowing to fund a highly speculative investment – a risky stock or a real estate flip in an unstable market – you're risking the invested money and the high interest or costs of the debt.
Persistent Losses: If your business continually loses money, borrowing to cover these losses prolongs the inevitable financial fallout. It's like using a band-aid on a wound that requires stitches. This explains the importance of addressing underlying issues causing persistent losses.
Thinking of a business loan? Here's what you Need to consider
Taking out a business loan is a big decision, and it should be a calculated move, not a blind leap. Before you commit to a loan, there are several factors you should scrutinize to ensure you're making the best decision for your business's health and growth.
Let's break it down.
1. Macro-economic factors
First, look at the broader economy. How are the Federal Reserve interest rates trending? Are they low enough to make borrowing cost-effective, or are they on an upward swing that might make your loan more expensive over time? What about inflation?
If inflation is high, your loan could cost less in the future, but your income might also lag. Understanding these macroeconomic factors can help you better assess the potential cost of your loan.
Additional reading: Check out our guides on navigating the banking crisis and surviving and thriving during a recession, as well as the U.S. Small Business Administration for resources to help you understand how these policies can affect your business.
2. Business life cycle
Where's your business in its life cycle? You might be tempted to borrow if you're just starting out or your business is struggling. But remember, the aim is to SCALE the business, not SAVE it.
Consider if your business is mature enough to secure financing. Are you at a stage where capital can help accelerate growth?
A loan for expansion, equipment, or opportunities can propel a stable business into its growth phase. However, a loan won't magically fix underlying problems in a struggling business.
3. Ability to repay
Before you borrow, make sure you have a solid repayment plan. Can you meet your loan obligations without straining your business finances?
Funders typically look at your debt-service coverage ratio (DSCR), which measures your ability to pay back your debt. They also consider your credit score, which reflects your repayment history.
Additional reading: Here's a guide on how to check and improve your creditworthiness.
4. Funding timelines
How quickly do you need the funds? Different loan options have varying approval and funding timelines.
Traditional bank loans might have lower costs but usually have a longer and stricter approval process. On the other hand, online funders or credit unions might offer faster approvals but at higher costs.
If you need funds urgently, consider alternative financing options like invoice factoring, merchant cash advances, or peer-to-peer lending.
Additional reading: Here's a comparison of different types of business loans to help you understand your options.
When is the right time to apply for a business loan?
Recognizing the right moment to apply for a business loan can be as critical as the loan itself. Timing matters, and so does the reason behind the loan. Understanding when your business might benefit from a cash injection can help you make the most out of borrowed funds.
Here are some scenarios where applying for a business loan could be advantageous.
1. Growth investments
Borrowing to invest in growth initiatives can be smart if these ventures increase revenues and profits.
Here's what we're talking about:
Expansion: If you're considering expanding your business – opening a new branch, venturing into new markets, or scaling up production – a business loan could provide the funds to make that move. For instance, a retail business might use a loan to open a new store in a high-traffic area, potentially multiplying its sales.
Product Diversification: Launching new products or services is another growth investment. Harvard Business Review provides an excellent perspective on when diversification makes sense.
2. Operational enhancements
Investing in operational enhancements can streamline your business, increase efficiency, and reduce costs.
Let's unpack it:
Infrastructure Upgrades: That could involve revamping your production facility for better output to investing in a modern CRM system to improve customer management. A loan can help you cover these upfront costs.
Equipment Purchases: New or upgraded equipment can improve your product quality, speed up your production time, or even open up new lines of business. A loan can help you purchase this equipment without tying up all your capital.
Tech Investments: The right technology can revolutionize your operations. It's time to invest in an AI tool for data analysis or upgrade to cloud computing for better data security and collaboration. Forbes has a guide on how to justify investing in new tech for your business.
3. Inventory and supply chain management
Borrowing money to manage inventory or secure your supply chain can be a sound decision, provided these actions enhance service and sales:
Inventory Management: If you anticipate a busy period – a retail business stocking up for the holiday season – borrowing money to stock up on inventory can help you meet customer demand and maximize sales.
Supply Chain Security: Securing your supply chain is crucial if your business relies on critical suppliers. A loan might allow you to purchase bulk quantities at a discount or ensure continuity of supply during peak demand periods.
4. Working capital financing
Sometimes, businesses need to borrow to meet short-term operational needs. That might include covering payroll during a cash flow crunch or paying rent while waiting for receivables.
If a loan helps keep your business running smoothly, prevents revenue loss, or allows you to seize opportunities, it's worth considering.
Keep in mind that every business is unique. What works for one might not work for another. Understanding your business's needs and financial health is essential before deciding when to apply for a loan.
Seize the opportunities amidst the uncertainty
The current economic landscape may seem rocky, but remember: with every shake-up comes the potential for fresh opportunities. Downturns have historically proven to be prime times for innovation and growth.
Ever heard of companies like Uber or Airbnb? They sprouted during the 2008 recession. So an uncertain economy isn't necessarily a red flag—it's a call to adapt and evolve.
And let's remember the technological revolution we're living in.
Advancements in AI, machine learning, blockchain, and more are reshaping our world, including the business landscape. Your business is part of this exciting wave, and these technologies present immense potential for efficiency and growth.
It’s an excellent time to take a hard, analytical look at your business.
Which areas hold the most growth potential? Where can strategic investment yield robust returns? If you need an injection of capital to fund this growth, remember we're here to help.
We can assist you in acquiring that crucial working capital you need to take your business to the next level. So, let's navigate these choppy waters together, harness the power of technology, and turn potential into progress.
Is your business at least three months old? Do you generate a minimum of $7,500 in monthly revenue? Congratulations, you've already met our basic qualifications if you answered yes to both!
The next step is to fill out our online form to prequalify your business. Choose One Park Financial to secure your business's future today!
Disclaimer: The content of this post has been prepared for informational purposes only. It is not intended to provide and should not be relied on for tax, legal, or accounting advice. Consult with your tax, legal, and accounting advisor before engaging in any transaction.