Small Businesses: What to Consider When Borrowing
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As a business owner, there will come a time when you need additional capital to meet short-term cash-flow needs or fuel your long-term growth. Depending on your business circumstances, you may decide to raise additional capital with either debt or equity.
If you decide to raise debt financing, there are important questions to consider and budgeting considerations to make in order to make the most out of the additional capital without incurring unnecessary risk.
- Budget accurately and conservatively
- Have a clear plan on how to use the funds
- Understand your repayment terms
- Don’t borrow too much
- Carefully consider interest rate options
- Consider collateral and personal guarantees
- Understand your cash flow
- Understand legal and tax implications
1. Have an Accurate and Conservative Budget
It’s essential to have a clear and accurate budget with conservative forecasts. This will help you avoid taking on too much debt. Moreover, a conservative budget will ensure that even if you don’t reach your targets, you will still be able to manage your debt repayments comfortably.
2. Have a Well Defined 'Use of Funds'
Have a clear understanding of why you need to borrow money, how you will use it and how it will benefit your business.
Having a clear understanding of what the capital will be invested in, when it will be invested and when the investment will start yielding returns will help you budget your debt repayments and will help you determine what type of debt you take out. Debt used for cash flow and liquidity management has very different terms compared to debt used for investment.
For instance, if you need to manage your payment terms to your creditors and debtors, a working capital facility or invoice factoring would be beneficial. Alternatively, if you want to invest in some equipment, longer term loans with extended repayment periods (such as installment loans) would be more suited to your needs.
3. Understand Repayment Terms
Understand the repayment terms of the loan, including the interest rate, repayment period, and any fees or penalties associated with early repayment or late payments. Consider the impact of these terms on your cash flow and financial projections.
4. Don't Borrow Too Much
Borrow only what you need and avoid overborrowing. Moreover, do not borrow too long in advance before the capital will be invested as you will incur unnecessary interest costs.
5. Carefully Consider Interest Rate Options
Interest rates significantly affect the total cost of borrowing. Compare interest rates from different lenders and understand whether the rates are fixed or variable. A lower interest rate can save money in the long run.
However, although some fixed interest loans may seem expensive now, you have a 100% insight into how much interest you will pay over the loan period. Alternativity, interest rates on variable rate loans may seem low today but they could increase significantly in the future. As a result, if you do select a variable rate loan, make sure that you still have enough cash-flow to meet repayments in a worst-case scenario.
6. Consider Collateral and Personal Guarantees
Some lenders may require collateral or personal guarantees to secure a loan. Consider the implications of using business assets or personal assets as collateral. Securing debt with personal or business assets can reduce the interest rate that is charged; however, your collateral may be repossessed if you are unable to pay back your debts.
7. Understand Your Cash Flow
Evaluate the impact of loan payments on your business’s cash flow. Ensure that you have a plan in place to meet the loan payments without jeopardizing your ability to cover other business expenses or maintain sufficient cash flow for operations.
8. Understand Legal and Tax Implications
Seek advice from legal and tax professionals to understand the legal and tax implications of borrowing money for your business. A benefit of debt over equity is that you can charge interest off against tax (interest tax shield).
In conclusion, taking on debt financing can be risky if you expose your business to significant downside.
As a rule of thumb, always consider what would happen in the worst-case scenario and make sure that your business will be able to survive this scenario.
Taking on a moderate amount of debt can be beneficial for your business if it is invested and managed well.
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