How to Make Smart Borrowing Decisions Including Not Borrowing

How to Make Smart Borrowing Decisions

Most people understand consumer debt: if you spend more on your credit card than you can pay back, you’re in trouble. But the decision to borrow money for a small business isn’t so clear-cut.

Not all businesses should take out a loan. So, which businesses should consider borrowing? How much debt is acceptable? Consider all options, including the right loan for your business, and how to make sure it helps you grow.

To answer these questions, we spoke with industry experts such as Drew Tonsmeire, an Area Director of the Small Business Development Center; Mitchell Weiss, loan expert and author of “Business Happens”; and Gregory Liegey, Vice President at Metrobank and volunteer with the SCORE Association.

Are there alternatives to borrowing?

Consider other options before deciding to borrow.

Being a responsible borrower means exploring alternatives to taking out a loan. For example, if you run a bakery that caters to corporate clients, you can avoid borrowing by working with your vendors. Instead of paying upfront for delivery services and waiting 30 days to get paid, you can enter into a contract with your delivery service. They can invoice you for their service, giving you 30 days to pay. Building a relationship with your vendors can help you manage your cash flow effectively.

How much can you afford to borrow?

Before borrowing money, consider how much debt you can afford.

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Small businesses should think like households when it comes to borrowing. Determine your debt coverage ratio by dividing your monthly earnings from operations by your expected monthly debt payments. This ratio should be between 1.25 and 1.50 at the lowest. The maximum amount you can borrow should be determined by this ratio.

For example, if you’re applying for a $50,000 loan over five years, your monthly repayment might be around $800. Your cash flow from operations should be 1.5 times that loan, or about $1,200 a month, after paying expenses. It’s crucial to see if you can handle the loan, even in a worst-case scenario.

How much should you borrow and when?

When you’re ready to borrow, know the amount and timing you need.

The key to borrowing money is having a reliable business plan for the next two years. Create a plan that outlines where the loan funds will be used and their respective costs. Obtain estimates from contractors or equipment dealers to determine the potential expenses. Consider factors like deposits, franchise fees, and hiring.

When creating your business plan, account for any lag between providing goods or services and receiving payment. Build a budget that forecasts the next two years and estimates the timing of your sales and expenses to guide responsible borrowing.

With a financial plan in place, you’ll know how much you need to borrow to cover cash shortfalls. However, ensure the borrowed amount is less than the maximum determined earlier. Apply for a loan several months before you need the funds.

It’s important to have a cash cushion, ideally six months of working capital, to handle emergencies. Understand the context and seasonality of your trade and calculate how much working capital you need based on the past six months.

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To determine emergency needs, use past recessionary cycles as a reference. Assess how your business performed during these periods and calculate potential expenses and losses. Staying ahead of financial challenges requires good management and anticipating your business’s future needs.

Remember to keep a close watch on your business’s financial health to avoid being declined for future credit opportunities.

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