Should You Take Out a Loan to Fund Your Small Business?

31 January 2023

If you need cash to operate and grow your small business, you have two options: debt and equity financing. Some business owners take on excessive debt because they won't relinquish control to investors. But others have the reverse problem — they refuse to apply for a commercial loan even though doing so would make good business sense. Being too debt-averse can limit growth, potentially causing your company to forgo a plant expansion, hiring plans, technology upgrades or a new offering. Here are some important considerations when evaluating whether to apply for bank financing.

Timing Matters

When deciding on the optimal blend of debt and equity capital, it's important to understand economic cycles. Current market conditions can be an important part of this decision. Typically, banks are more willing to lend money when the economy is strong. But downturns also can provide opportunities for your business to expand — and these opportunities may require an infusion of capital.

For example, the COVID-19 pandemic caused a global economic downturn, followed by high inflation and supply chain disruptions. Some economists have been predicting a recession, despite solid job growth. While the U.S. economy is underperforming, your business might decide to expand into a foreign market. Or you might want to acquire a struggling competitor (or its assets) at a bargain price.

Discuss your capital needs with your financial advisors early in the planning process to determine the criteria for enticing private equity investors or obtaining a business loan.

Equity Financing

Business owners often seek equity financing before they apply for loans. But some entrepreneurs may be reluctant to give up equity — and control over daily business decisions — in exchange for capital. Yet this option might be necessary to take your company to the next stage of growth.

In the "seed" stage of development — before actual sales have been made to customers — start-ups may find it challenging to attract lenders based on an unproven business concept. If entrepreneurs don't have cash on hand, they may rely on friends and family members as they ramp up operations. The best time to seriously discuss borrowing from a bank is when your company has an established customer base that it wants to grow.

Even then, bank loans may not be sufficient to fund your business's growth. Plus, access to bank loans may be limited during downturns. So, equity capital can help bridge the gap. Additionally, the right private investors can bring significant business expertise and advice that can help you pursue growth opportunities.

Lending 101

Business owners borrow money for two reasons. First, within reasonable limits, debt tends to be cheaper than equity. That's because creditors are paid before equity investors when a company liquidates. However, as a business takes on more debt, it becomes riskier, and eventually the cost of debt will catch up — or exceed — the cost of equity. The second reason is that interest on debt is generally tax deductible for small businesses, though business interest deductions for larger businesses may be subject to income-based limits under current tax law.

If you decide to apply for a bank loan, you'll need to provide more than just tax returns and financial statements. You also should submit a formal business plan and explain how you intend to use the funds. Do you need extra money to cover operating expenses and fund the cash conversion cycle (the time it takes to convert a sale into cash from the customer)? Or are you planning to invest in new equipment or buy a struggling competitor to expand market share? Your business plan and the availability of collateral will help determine which types of bank products and loan terms make the most sense for your situation.

The lender will evaluate the soundness of your business plan, as well as your personal education, experience and financial track record. Small business owners are often required to personally guarantee their business loans.

Experienced financial advisors have a solid understanding of what's needed to successfully apply for a business loan. For example, a key metric that lenders consider when evaluating prospective borrowers is the debt-to-equity ratio. (See "Eyes on D/E Ratios," at right.)

Asset-Based Lending

Business assets are often pledged as collateral for loans. An example of a typical asset-based lending arrangement is when you buy a vehicle or real estate with a direct loan. If your historical cash flows aren't sufficient to cover your loan payments, you also might be asked to secure a line of credit with your company's receivables or inventory.  

Lenders typically prefer "liquid" collateral, such as accounts receivable or inventory, that can quickly be converted to cash, over hard assets, like equipment. Pledging assets lowers the lender's default risk, because the bank can recover its losses by repossessing and then selling the assets. So, the interest rates on asset-based loans are usually lower than for unsecured loans. However, interest rates can vary significantly depending on your personal credit history, business cash flow and the types of assets pledged as collateral.

Receivables Factoring

An alternative to a traditional bank loan is accounts receivable factoring. In these arrangements, a business sells its receivables to a third party (the factor) at a discount from the book value. The advance rate depends on the type of factoring arrangement (recourse or nonrecourse), back-end fees and perceived risk of default. The factor takes over responsibility for collections while the company selling the receivables gets cash.

While outsourcing collections might seem appealing, there are some downsides to consider. For example, factors are unregulated, and some take advantage of capital-starved businesses. In addition, some might aggressively pursue debtors (the company's customers), thereby compromising future revenue. A contract's fine print also may camouflage adverse clauses, such as excessive fees for processing and early termination. Some nonrecourse factoring arrangements even require the company to assist the factor with collections.

Eyes on D/E Ratios

The debt-to-equity (D/E) ratio is a measure of how leveraged your company is. It's calculated by dividing the book value of the company's total liabilities by the book value of shareholders' equity. Different industries have different capital needs and growth rates — and, therefore, the optimal ratio varies across industries.

D/E ratios are most effective when used to compare companies in the same industry or to evaluate the change in a single business's capital structure over time. A high D/E ratio is generally indicative of greater risk. Alternatively, a low D/E ratio may show that a company isn't using debt — which is generally a cheaper source of financing — to expand and grow.

Businesses with a high D/E ratio (or a D/E ratio that's continually increasing over time) typically have more difficulty obtaining credit approvals. And with a high D/E ratio, even if you do get approved, your interest rate will probably be higher than companies with low D/E ratios.

Before you apply for a loan, ask your financial advisor how your business's capital structure compares with its peers. This can help you understand your application's odds of getting approved and how high your interest rate will be.

Optimal Capital Structure

Don't let a lack of cash limit your business's growth. Consult your financial advisor for help achieving the right blend of debt and equity to lower your cost of capital and take your company to the next level.

 

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