Almost every startup entrepreneur reaches a point where there are many promising ideas but little money to implement them. In such moments, it looks almost certain that cash is the only thing hindering them from achieving their dreams of striking it rich. Getting a loan sounds like a brilliant idea, and with so many banks and other institutions willing to lend money, the temptation is strong.
Some entrepreneurs may find themselves in a dilemma. They don’t want to risk stunting the growth of their young business because they don’t have capital to grow it to its full potential. On the other hand they don’t want to accumulate too many liabilities in a business that is like a toddler learning how to walk.
At such moments it is good to analyse what financing will do or not do to your business, now and in future. There are two types of financing that any business will have: the owner’s capital and loans.
Experts agree that for a small business at the startup stage, loan financing should be the last option. You should consider borrowing when the growth that you want is only achievable beyond what you can inject on your own, and when the returns expected are more than the cost of the loan.
The cost of the loan comprises interest, negotiation fees, chargeable security and other charges accrued before and after the loan has been advanced. There are two things you should consider before deciding to take a loan.
First, establish whether and why you need the loan. Most startup entrepreneurs take loans too early in their business growth. In retrospect, many realise that if they had delayed a little longer, it would have been much better for the business.
Putting up another branch, buying more inventory, expanding product range and doing more marketing to improve efficiency and market share are often cited as reasons for taking loans. But one still needs to question whether it is the best option and whether the timing is right.
Before signing a loan form, ensure the money is going to develop business productivity. It should increase some kind of capacity or fulfill some sort of working capital requirement, rather than opening a new office, buying furniture or some other luxuries or even essential but not urgent income-generating items.
A good loan is invested in working capital to expand your business while bad loans are taken to pay off other loans or to finance unnecessary items for your business. Secondly, consider whether you can afford to repay the loan.
Lenders have their own way of establishing your ability to repay the loan. In essence their criteria may not work for you, and even if it does, it may not serve your interest. For instance, lenders usually focus on what is called the 5Cs of credit: your character, capacity, capitalisation, condition, and collateral. These 5Cs of credit do not adequately factor in one of the most important elements of business: the bottom line.
Your character, your capacity as demonstrated by your business turnover, your equity in the business, market conditions and the asset you can give as security could have little to do with the profitability of your business. High turnover does not equal to profit. Loans only make sense if you can repay from your profit.
This is why it is crucial to take a hard look at your books to assess if your cash flow and profit can afford to pay for the monthly interest and principal amount.
Cash flow is important because you need it for smooth operations. If you are making profit but run out of cashflow, your business operation will halt and ultimately resort to losses.