While debt financing helps businesses come up with quick cash, there are risks business owners should know of. Learn more about small business financing.
Debt financing can be a viable way to shore up cash for your business, but it does come with some risk. Make mistakes when borrowing money and you could end up paying more than you should.
Anyone who has operated a small business knows the dangers of not having enough cash. But many business owners wait until it’s almost too late to look for ways to shore up their cash reserves. No matter why they waited, it puts them in a difficult predicament. They end up overpaying to borrow money or don’t take enough to fully fund the endeavor. That often has a snowballing effect, in some cases rendering the business inoperable.
But that doesn’t have to be the case for your business. By avoiding the mistakes of the business owners before you, you can prevent your enterprise from running into debt financing headaches. See the following top debt financing mistakes you'll want to avoid.
Mistake #1: Waiting Until the Last Minute to Borrow Cash
Running a small business requires you to wear many hats, making it easy to neglect some aspects of operations while you focus on others. One area that tends to get overlooked is cash flow management.
As long as the lights are on and payroll is met, little thought is given to future cash needs. That's until a big order comes in or a new opportunity to reach potential customers arises. Then and only then, business owners realize they need cash -- and need it yesterday.
To prevent that from happening to your business, a good rule of thumb is to have at least two months of expenses in the bank. That way, if you need cash to take advantage of an opportunity or fund operations, money is at the ready. If sales slow down unexpectedly it also cushions the blow.
It’s also important to keep track of your cash flow and project a year out. Any seasonal slowdowns and pickups that could affect sales and inventory must be accounted for. If you need to borrow money, you’ll know in advance, giving you the time to shop for a low-cost loan.
Mistake #2: Not Knowing the Total Cost to Borrow
Nothing in life is free, and that’s particularly true of small business loans. Regardless of the lender, you're going to pay. How much depends on your credit score, the type of loan, amount of the loan, and financial institution you're working with.
There are a number of fees that come with borrowing, although some are negotiable. There’s the loan origination fee, underwriting expenses and closing costs, to name a few. If your loan is a Small Business Administration loan, there’s a loan guarantee fee that can range from 0.25% to 3.75% of the loan.
Often, time-crunched small business owners gloss over the details, just happy to secure the needed funding. They sign on the dotted line, choosing not to sweat the small stuff. But without reading the fine print, you won’t know the total cost to borrow. Without that, it’s impossible to determine if it makes sense. ROI is critical, even with a loan.
If reading the full terms and conditions isn’t possible, the Annual Percentage Rate (APR) is the next best thing. The APR includes the interest rate and fees, giving you a clear picture of the total cost. Your lender can also provide you with the total dollar cost of the loan, which is a handy way to quickly determine your possible ROI. For example: you might borrow $20,000 and owe $22,000 in total; the total dollar cost of the loan is $2,000.
Mistake #3: Not Realizing Their Personal Risk
For small business owners who are new in the market, getting a loan can be challenging. There’s little to go by to gauge success. To overcome that, lenders look at the business owner’s personal credit score in addition to the business financials. That means your personal financial habits have a direct impact on the cost of borrowing for your business.
Then there’s collateral. Small business loans are typically secured, which means some form of collateral is required. If the business doesn’t have enough assets to offer up, the lender could require the business owner to put up personal assets. That personal liability comes as a surprise to some borrowers who don’t take the time to read the fine print. It also causes some to put on the borrowing brakes when they realize what’s at stake.
Mistake #4: Failing to Shop Around
You wouldn’t get a mortgage without shopping around, nor should you take out a small business loan without first weighing your options. Shopping around can be a big cost-saver. It's time-consuming, yes, but well worth it. You’ll know what the best rates are and which lender has the terms that are right for you.
Outside of the interest rate and fees, when shopping for a small business loan, pay attention to whether the interest is fixed or variable. If it's fixed, the interest rate stays the same through the life of the loan. If it's variable, it changes with market rates. The latter interjects more risk into the business. Compare APY instead of interest rate and make sure the terms match your needs. The amount of collateral, repayment schedule and terms are also things to consider. Customer service can’t be ignored either. You may have questions and will want a lender that can answer them.
Mistake #5: Borrowing More Than You Can Afford to Pay Back
The life of a small business is directly tied to cash flow. Have too little of it and that means the business might not make payroll. Borrow too much and you may struggle to pay it back on time. Either could mean the end to a business.
That’s why it’s important to know precisely how much you need to borrow before you even think about contacting a lender. You don’t want to borrow too little to move the needle. Nor do you want to borrow too much and overspend.
To determine how much you can afford to borrow, look at your debt-to-income ratio. The ratio compares the amount of money coming in with the amount going out. If the debt-to-income ratio for the business is high, you may want to rethink the loan. But if it's low, it's a signal it's acceptable to take on new debt.
A good rule of thumb is to never borrow more than you need. The key to a successful loan is to increase sales by adding value to the business.
SBA Loans Help You Avoid Costly Mistakes
Putting in the effort goes a long way in avoiding costly borrowing mistakes when shopping for a small business loan. If you don't have the time or inclination, consider an SBA loan. Backed by the Small Business Administration, these loans offer flexible borrowing amounts and repayment options. They come in fixed and variable interest rates and can last as long as 25 years. Geared toward borrowers that may have gotten turned down elsewhere, these small business loans offer reasonable terms, including low down payments.
An SBA loan may make the most sense for your business, or a loan from a private lender could save you more. Either way, make sure you know how much you need and read the fine print before shoring up cash via debt financing.
The views expressed by the authors are not necessarily those of Fifth Third Bank, National Association and are solely the opinions of the authors. This article is for informational purposes only. It does not constitute the rendering of legal, accounting, or other professional services by Fifth Third Bank, National Association or any of their subsidiaries or affiliates, and are provided without any warranty whatsoever. Deposit and credit products provided by Fifth Third Bank, National Association. Member FDIC.