It is quite common for a small business to take on debt to finance its expansion or maintain cash flow. Yet borrowing money is not a panacea for every small business financial issue. Below are some instances when it may not pay for your business to pursue a loan.
This may seem obvious, but many businesses pursue loans without having a clear idea of whether or not they can afford to assume the debt. Ask yourself: what is the purpose of the debt and what will be its impact on company finances? In other words, can you afford the debt and can you make the monthly payments? In order to get a clear answer to this question, you may need to sit down with your CPA or financial advisor to run various projections. In general, a loan should be able to provide sufficient cash flow to allow your business to make regular payments that can be budgeted for. Otherwise, the loan can quickly become a drag on cash flow, and hurt your ability to run your company profitably.
Taking on debt to cover other debt payments is a self–perpetuating way to get your business into deeper financial straits. It cannot only add to cash flow pressure, but can also put the life of your business at risk. In fact, many financial institutions will prevent you from using a loan to pay off creditors — for example, this is strictly prohibited for SBA–guaranteed loans. On the other hand, refinancing debt to consolidate several loans into one can be an effective way to decrease your overall interest rate and spread the loan over a longer period of time.
Fixed expenses are those business costs that do not change with the volume of business — such as rent, utilities, insurance payments, etc. A business generally should be able to pay these out of cash flow. Variable expenses — such as manufacturing costs, inventory, or advertising — are generally better targets for debt financing, since these investments are more likely to help boost your business' cash flow.
Short–term loans and lines of credit (LOC) are useful vehicles for managing the ups–and–downs of cash flow. Unfortunately, some small businesses turn to these financing methods as alternatives to longer–term vehicles, using them, for example, to purchase equipment or finance expansion. A short–term loan or LOC can quickly become a financial burden that can't be paid down quickly. As a rule, if short–term loans cannot be repaid in under a year, or cannot be easily converted into medium–term (5 to 7–year) debt with consistent, affordable payments, then they are not the correct financing source.
If your business needs new equipment — such as computers, phone systems, or other capital gear — but doesn't have cash on hand, leasing may be a better option than taking out a loan. Although your business will not own the equipment it leases, it can avoid taking on debt or tying up lines of credit that can be used for other areas of business. In addition, leasing can often be more beneficial tax–wise, as lease payments are fully deductible, but equipment purchase deductions may be limited by depreciation rules.
The previous content is provided by OPEN: The Small Business NetworkSM from American Express.