The growth of alternative lending has made taking out a small business loan a much faster and simpler process than it has ever been before. In many cases, you can fill out an online application, be approved within 24 hours and have cash in hand within a few days.
While that’s good news for entrepreneurs in need of financing, it also creates more personal responsibility than ever to make sure small business owners are making the smart financial choice in taking on business debt.
Not sure whether you should take out a loan to start or expand your business? Evaluate these five statements to determine whether taking out a business loan is really the best decision for you.
1. Your Business Has Reached Its Growth Limit Without More Funding
Have you run out of growth options to pursue because you’re limited to the cash you currently have on hand? Or are there still things you could do to increase revenue on your own?
Your growth pattern is often a good first marker of whether a business loan is a good idea. If your sales volumes are holding steady but not growing, then an influx of capital may be just what you need to take things to the next level. If you’re already hemorrhaging cash or seeing declining sales, adding a loan payment may only make things worse.
2. You Plan to Use the Funds in a Way That Will Positively Affect Your Bottom Line
Better perks for employees? New office furniture? A team retreat to New Zealand? Every business owner has a wish list of “nice-to-haves” that they would love to contribute to their business. But when taking on business debt, it’s important to make sure that you’re using your loan in ways that will directly impact your bottom line. After all, if your loan does not help your business make more money, how will you pay back the funds you borrowed, plus interest?
Expanding to a new location, buying new equipment or purchasing inventory at a discount are all uses of loan funds that can potentially increase revenue, making it more likely that your business loan will be a good investment. Marketing can also be a good use of loan funds, as long as you have a reasonable and measurable expectation of resulting sales.
Before taking out a small business loan to check items off a wish list, consider whether you can tie those expenses directly to revenue growth. If not, you may risk adding undue stress as you attempt to make regular loan payments without more cash coming in.
3. You Know How Much Funding You Need, and How It Will Change Your Business
A small business loan can only be a good investment if you use it efficiently. Identify exactly how you will use the funds, and research estimates of those costs. Then create a realistic sales projection detailing how the investment will affect your revenue going forward.
If you add capital to your business without making a plan for each dollar, you’re just making it easier to squander. It’s easy to turn around and realize that you’ve spent all that extra cash, one small expense at a time, in ways that do little to help your business grow. Having a plan for that money ahead of time will help you decide whether a small business loan is a good idea, and it will make sure that you use the funds wisely.
4. You’ve Researched Alternative Funding Options
Taking on a small business loan can be a great way to get funding for your business, but it isn’t the only option available. Before you approach a bank or alternative lender to take out a loan, it’s important to consider all of the different ways you might be able to fund your business growth.
Do you have friends or a family member who may be able to help? If so, you could arrange for a loan through this person at a more favorable rate than you would get from a lender. Or, a friend or family member may be interested in investing in your company in return for a share of future profits. If you choose this route for a loan or equity sell, however, be careful to be explicit about the terms of the agreement and put everything in writing. Financial issues can quickly bring tension to your personal relationships if the expectations aren’t clear.
You could also consider working with an angel investor or venture capital firm to fund your business. While this option does involve giving up a significant portion of equity, the expertise that these financiers offer could be invaluable to taking your venture to the next level.
Crowdfunding your business through a platform like Kickstarter or IndieGogo can be a lot of work up front, but it can also help generate buzz about your company and save you from giving up equity or paying interest on a loan. Remember, however, that many crowdfunding platforms require your project to be fully funded in order for you to collect any funds. This can make it can be a big risk if you need to collect a large amount of capital.
5. You Can Afford the Small Business Loan Your Business Needs
After considering all of the options, you might still decide that a small business loan through a bank or online lender is your best choice—but knowing your options will help you make that choice with confidence.
No matter what the particular use, there’s no such thing as a good debt investment if you’re taking on a loan you can’t afford. To make sure that a small business loan is the best decision for your business, you need to confirm that its size is appropriate for your business’ size and revenue. Equally as important, make sure that you can afford to make consistent debt payments under the terms you qualify for.
To determine whether you can afford to pay back your loan, use the debt-service coverage equation:
This commonly accepted equation is a great measure of the affordability of your small business loan. Essentially, the equation states that your typical end-of-month cash on hand needs to be 1.5 times greater than the monthly payment on your loan.
A debt service ratio of 1.5 is considered average—so you may decide that you’re comfortable with a higher risk (closer to 1) or more conservative ratio. Either way, applying this equation to your anticipated debt payment will help you ensure that you can make your loan payment on time, every time, without causing undue stress to your bottom line.
Deciding Whether a Small Business Loan Is Right for Your Business
Are these five statements true of your business? If so, you’re likely in a position to comfortably say that a small business loan really is the best decision for your business. You’re ready to find the best loan available, sign that dotted line and set about making your business goals a reality.
If not, go back to the drawing board and re-evaluate which of these statements needs some reconsideration. You might find that you need more time, need to make some adjustments to your finances or need to consider other options about how best to fund your business.