When is a small business loan the right choice?
by Joseph Lizio - July 13, 2009
As a former commercial lender, I have seen all types of small businesses seeking capital; either for start-up funding, growth capital or a plethora of reasons from payroll to personal. Some get what they want, some do not. But, most business owners do not understand if a loan is the right way to go for this capital or what banks require from business owners seeking financing.
So, when is a business loan right for your small business?
Here is a very common situation. A business owner has an opportunity to generate some additional revenue but needs outside working capital to pull it off. When asked, the business owner states that he needs $50,000 for 36 months and states that he is ensured of generating some $1,450 per month. On the surface, that sounds great. $1,450 per month for 36 months ($1,450 X 36 = $52,200) exceeds the original $50,000. The business owner thinks this is a no brainer because, taken as is, this opportunity is a positive present value (PV) of about $2,200. Nice additional cash flow.
But, for the business owner to take advantage of this opportunity, he has to borrow the money. That adds an additional cost of say 8% per year for the three years. The 8% interest not only eats up the PV of $2,200 but actually costs the business owner an additional $4,200 for a total of $6,400. This makes it a negative present value for the bank and the business.
Great idea if you already have the funds. Not so great if you have to borrow the capital.
Now, if this opportunity generated monthly revenue of $1,567, the PV of this opportunity would be essentially zero. The $1,567 would pay back the original $50,000 and the 8% interest to borrow the money. Again, the bank would not lend against this. The bank asks, what happens if, over the next 36 months, something changes and the business owner does not realize the minimal $1,567 per month? What happens if the business owner misses that mark for just one month?
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Banks not only want the business to be able to cover the principle and interest payment, they want a cushion of say another 25% or more (depending on the loan amount and the strength of the business) to ensure that the business could still cover the debt payment should the business have a slow month or period.
So, for a bank to lend against this, given all else with the business is in order, would be for this opportunity to pay off or generate some $1,959 per month - providing a 25% monthly cushion for the bank and the business. And, if all goes as planned, the business not only gets the funds it needs and generates new revenue but gets to keep the 25% cushion.
Business owners get into similar situations all the time. They figure that they can make some extra money if they were able to get their hands on a little capital. But, if the opportunity does not bring in more than it costs, it is not worth it, to the bank or to the business. Sometimes, if borrowing money, if the business loan is not right for the business - don't wait for the bank to say no - either move on to a new, more profitable opportunity or find another, cheaper means of financing.
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When is a small business loan the right choice - Business Money Today