A love of accounting is probably not the primary reason most entrepreneurs decide to start a business, but I think most of us would agree that at least a basic understanding of good accounting and bookkeeping practices are an important part of running a business. Likewise, mastering the ins and outs of financing is important if your business relies on borrowing to fuel growth or fund working capital needs. Although there are more financing options available today than ever before, it’s more important than ever to understand some of the basics of small business borrowing so you can make informed decisions for your business.
Regardless of the particular loan or the particular lender, here are two things you need to consider when evaluating any financing options:
How much does the borrowed capital cost?
Loan costs will vary from lender to lender; and, depending upon the loan type, repayment terms can be anything from a few months to several years—all will impact the cost of the funds you borrow. As a rule of thumb, a shorter-term loan of six months will likely have a lower overall cost than a loan of several years, but the periodic payments will be higher. It is therefore important to understand how the length of the loan term impacts overall cost and the size of the periodic payment.
Most of us are familiar with how to think about a mortgage or an auto loan. Determining the right fit for a business loan, however, is a little bit different and may be more complicated.
For example, consider the scenario where you’re borrowing to purchase inventory. The cost of borrowed money could potentially impact the profitability of the inventory you’re purchasing. For example, if you plan to turn over the inventory in a relatively short period of time, you may be better off paying less interest and a higher periodic payment over a a few months rather than several years. More specifically, if the accumulated interest on $10,000 of inventory is $4,800 on a loan with a term of four years and you’re margin is 50 percent (or $5,000 in profit), that particular loan might not be a good idea if you can get the same $10,000 for $1,500 in cost on a shorter term loan. That’s why, in terms of a business loan, it makes sense to consider the total loan cost when comparing one loan to another.
Do you have the cash flow to make the periodic payments?
Determining whether or not your business has the cash flow it will need to make the periodic payment is just as important as determining the total cost of the loan when evaluating whether or not any particular loan makes sense. This is why you need to consider the loan terms. Shorter-term loans will likely include a lower overall cost of funds than a longer-term loan but will usually include a higher periodic payment—which could become problematic for a business with unpredictable cash flow.
For example, if most of your cash flow happens at the end of the month or on a quarterly basis when your customers pay larger invoice amounts, and that cash flow carries you through the following period, a short-term loan that requires daily or weekly direct debits from your business checking account (a common practice by short-term lenders) might not be a good idea. Whereas if your business has a consistent influx of cash into your business every day or every week a short-term loan could be a good fit.
In that regard, it’s important to understand the nature of your cash flow, as well as whether or not you have a positive balance when your loan payments are due.
Understanding Business Loans
Although the basics of a loan: principle, interest, term, and periodic payment apply to all loans, when evaluating a business loan, take the time to make sure you understand the total cost of the loan to make sure that cost is appropriate to your loan purpose (see the inventory example above). And, don’t forget to consider the nature of your cash flow when you look at loan term and payment frequency.
If you do, you’ll probably notice that some loans are better suited for some loan purposes than others. You may also discover that a loan that you may have initially rejected makes a lot of sense for your particular need. The increased options available today require borrowers to be savvier when evaluating a potential small business loan than they were just a few years ago.
In the same way we might agree that a business owner needs to understand the fundamentals of the financial side of running a business to be successful, if borrowed capital is part of how they fund their business, they need to become savvy when evaluating one financing option over another.