5 Things To Know Before Taking A Business Loan

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There are different ways of raising funds for a business, and borrowing is just one of them. When a business owner takes a loan from the bank, the business goes into debt. This debt must be repaid at a certain point in time with interest. this method of funding a business with borrowed funds is called Debt financing.

So what happens if the business owner fails to repay its debt due to unforeseen circumstances?

This is one risk business owners take when borrowing money to fund their business. If the business fails to generate enough money to cover its debts, then the business is said to be insolvent, and may soon declare bankruptcy, if nothing is done about it. But it doesn’t have to get so bad. Here are five things business owners should know before taking a business loan.

Have a debt repayment plan 

Don’t simply assume the business will pay off its debt. If you decide to borrow and invest in your business, you should consider having a plan on how to repay the debt. Planning will help you look deeper into the business’s finances and know if and how it will pay back the debt. 

Know how much debt your business can handle

Debt management starts with knowing how much debt your business can handle. This is known as the debt capacity of the business. Debt capacity can be assessed with the help of the balance sheet. This is a financial statement that shows the business’s assets, liabilities and equity. Another financial statement that may be helpful in the assessment of a business debt capacity is the profit and loss statement. This shows how much money the business is making after the expenses have been deducted. Both financial statements can be helpful in deciding how much debt a business can take without endangering its future. 

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Debt restructuring

Sometimes a business’s financial forecast may not turn out as expected. In such cases, the business finds itself in financial distress and struggles to repay its debts. One way businesses can avoid bankruptcy at times like this is by renegotiating the terms of their debt. In the business world, this is known as Debt restricting or refinancing. Some strategies used in debt restructuring include, reducing interest rates, extending payment terms, or cutting loan balance. 

Understanding Debt-to-Equity ratio

One of the most effective metrics for monitoring a business’s performance is the debt to equity ratio. This is simply a ratio of the total debt of a business to its equity. A business with a  high debt to equity ratio is said to be levered. Although this term can be used to also describe a business with a lower debt to equity ratio, highly levered firms indicate that most of the business’s operations are debt financed.

While a business with a lower debt to equity ratio relies more on equity to finance its operation. A high debt to  equity ratio can spell doom for a business with poor cash flow. However, it can also increase the business’s return on equity. It all comes down to the nature of the business. A business can be highly levered as long as it has enough cash flow to service its debts. If not,  then the business can lean more on equity to finance its operations and keep debts to a minimum (lower debt to equity ratio). 

Adopt an alternative means to finance your business

Debt is not the only means of financing a business. In the previous section I hinted on equity financing, that is, using equity to finance business operations. Aside from equity, here are other ways a business can cut down on debts.

Leasing instead of buying - a business can opt to lease equipment or machinery instead of buying if it is more profitable to do so (short term). Leasing is safer when the business isn’t sure of the investment outcome. At the end of the lease period, the business owner can decide if it is worthwhile to borrow money and buy the equipment or not. 

Reinvesting earnings - retained earnings is money the business has made but not yet paid out as dividends. This can be reinvested into the business as an alternative to borrowing. 

That’s all for now folks.

Until next time, stay inspired and keep chasing your dreams!

Cheers,

Alex