How to Be a Responsible Borrower
In this guide, you’ll learn:
Borrowing money can be a key way to fund your business–allowing you both to safeguard against emergencies and to grow.
The most important tool to help you decide how much to borrow and what kind of financing to seek will be a detailed and realistic 24-month business plan.
The best time to get a loan is when you don’t direly need it, so plan ahead and start thinking about funding your business today.
Most people understand the basic math of consumer debt: If you rack up more costs on your credit card than you can pay back, you’ll be in trouble. But when it comes to debt for a small business, suddenly the picture seems much muddier.
Our number-one goal at Fundera is to help small businesses succeed. Usually, that means connecting them to the best alternative lenders, but everyone’s situation is different and not all entrepreneurs are at the stage where borrowing money is the best course of action for their companies’ future. Helping you succeed means being honest about that.
What sorts of businesses should think about taking out loans? How much debt is appropriate, and how much is too much? Out of the universe of options, which kind of loan is right for your business, and how do you make sure that the loan helps you grow instead of weighing you down?
For the inside scoop on these questions and more, we spoke to Mitchell Weiss, author of “Business Happens” and loan expert; Drew Tonsmeire, Area Director at one of the Georgia service centers of the Small Business Development Center; and Gregory Liegey, vice president at Metrobank and volunteer with the SCORE Association, which offers mentorship programs to entrepreneurs.
Do You Need to Borrow?
Before choosing to take out a loan, consider all the options for your business’ growth.
Sometimes, to be a responsible borrower means looking for ways to not take out a loan. One simple option to make sure your business runs smoothly is to work with your vendors. Let’s say you own a bakery and cater to corporate clients, but don’t get paid until 30 days after you cater an event. Maybe one of your vendors is the delivery service that sends your baked goods around town. If you have to pay for delivery upfront, but then wait 30 days to get paid yourself, that’s difficult. But if you write a compelling business plan, you might show it to your delivery company and foster a vendor relationship.
“The sooner you begin a relationship, the much more likely it is they will join with you,” Tonsmeire says. Ideally, the delivery company might agree to let you pay 30 days after their services are rendered, too, for the sake of cultivating you as an ongoing customer. In a sense, this constitutes a very short-term, interest-free loan of services, and it could help your operations significantly.
How Much Can You Afford?
If you do decide to borrow money, here’s how to start thinking about it.
Weiss says, “I love small businesses because they think with two parts of their brain. They think like business people, but the best of them run that enterprise the way they run their household. In running your household, you know you’re not going to spend more than you can afford to pay back. In running a business, don’t do anything differently.“
To be a responsible borrower, Tonsmeire recommends figuring out your debt coverage ratio. “How much profit do you earn from your operations, not including interest or depreciation or amortization? This is also known as EBITDA. Now, how does that compare to your debt service, or the principal plus interest on the loan?” he asks. “That ratio has to be above 1.25 in the traditional banking world and many banks are pushing this to 1.5.” Regardless of whether you’re getting a loan from a bank or non-bank lender, a debt coverage ratio of 1.0 is a good rule threshold to use: below that, you simply don’t have enough profits to make the financing worth it.
Let’s suppose you were going to apply for a $50,000 loan over five years. Your principal and interest could be somewhere around $800 a month, Tonsmeire says. “After you pay expenses […] cash flow from your operations [should be] about one and a half times that loan. In this example, that’s close to about $1,200 a month […] Can you afford that, and how tight is this going to be?” For many businesses and to be responsible borrower, it will be important to have a forecast of whether you can handle the loan even in a worst-case downturn scenario.
Liegey offers another rule of thumb: debt-to-income ratio. Divide your current monthly debt obligations by the monthly income you bring in, he says: “Usually a bank is looking for around 40% or less.” Besides impacting your likelihood of landing a bank loan, this is also a useful number for you to know on your own, to determine if it’s wise to take on any more obligations.
When & How Much Should You Borrow?
Once you decide to get a business loan, decide how much you need and when you’ll need it.
Unless you can say with absolute certainty that your business will grow consistently, that there’s no seasonality, and that your company won’t be hurt even if the economy crashes, you need a line of credit. Says Weiss, “We’re all subject to changes in the economic environment, damage from things that happen in the world that we can’t control.”
It’s a good rule of thumb to sock away six months of working capital in case your business hits hard times, but it’s also important to remember the context and seasonality of your trade. What exactly will you use that financial cushion for? And when you talk about saving up six months of capital, are you basing that on a monthly average? Are you basing it on the past six months? Don’t forget that you’ll need to steer your ship through both clear and choppy waters.
To determine how much you should have to be a responsible borrower in the event of an emergency, look backwards in time. Weiss says, “If your business has been established for some time, look back to the last recessionary cycle. How far off sales were you? How long to recover? How much did you lose? If you’re a new business, use a proxy. Look at what happened to small businesses in your industry during the last two economic downturns […] What expenses would you cut? How many months of losses would you expect? How would you fund that?”
Keep your finger on the pulse of your business. Weiss notes that you might be declined even for a pre-existing line of credit if your business goes downhill very quickly, because you will be asked for updated financial statements: “The only way to stay ahead of that is with good financial management, to anticipate where the business is headed and start funding yourself through borrowing in advance of [a crisis].”
Perhaps the biggest key to borrowing money is creating a reliable business plan for the next 24 months. Figure out what you need the money for and how much each of those things will cost. Seek estimates from equipment dealers or contractors, and if you’re a startup, think about what money might be outlayed before you even open, like deposit, franchise fees, hiring and so on.
When coming up with this business plan, be mindful of the lag between when you provide goods or services and when you get paid. “You can make a sale, but when does the cash change hands? In the same way, you have an expense, but when do you actually have to pay it?” Tonsmeire says. It will take time, but you can build a long-term budget that forecasts the next 24 months, and guesstimate the timing of your sales and expenses to come up with a predicted net income to guide your borrowing.
What Kind of Lender Is Right for You?
With amount and timing decided, explore your options beyond traditional banking.
Most small business owners know that the big banks, such as Chase and Citi, offer small business loans. However, many of these large institutions have stopped or restricted their lending since the Great Recession, and it is valuable for small business owners to have a full look at all of their options.
If you decide not to go the bank route, you have a few options. You can take out a consumer (rather than a business) loan by tapping into a home equity line of credit, or you can explore alternative lending options. “Businesses get commercially rated just like a consumer does, so it’s important to build that credit file […] Typically, alternative financing is more expensive because there’s more risk,” Tonsmeire says, but Liegey adds that alternative lenders tend to be “a little more lenient on lending terms.”
Often, banks take weeks to review financial statements, tax histories and business plans, and generally require solid credit scores, serious company track record and business collateral. On the other hand, alternative lenders may use more creative means to determine whether you’re worthy of credit, like checking out the reviews customers have left for your business on sites like Yelp, looking at your business’s accounting software and even taking into social media account activity. Partly as a result, alternative lenders like OnDeck can approve a loan in under a week, a great option for businesses unwilling or uninterested in waiting for several weeks or months’ time.
Which Loan Is Best for your Business?
Carefully study the terms to make sure each loan is appropriate for your needs.
There are three main things that affect your loan: The total borrowed, interest rate and terms, and the total time you’re borrowing. “Changing any of those three affects your payment. Do I need $20,000 or $40,000? Do I want 6.6% fixed or 4.5% variable?” Tonsmeire says. “You’ve got to think through not only, ‘what is my condition right now’ but what will it be 24 months from now? Is the market still going to be in the same condition? Interest rates are probably going to rise a little, but how much is a little? Would a 2% increase in my interest rate affect me greatly two years from now?”
In choosing responsible borrowing terms for your financing, Tonsmeire recommends breaking out short- from long-term expenditures: “Try to match the kind of money to the kind of asset you’re trying to buy.” He defines a long-term asset as something that will last longer than a year. If you were starting a bakery, equipment like ovens would be long-term assets because you’ll use them for years, while purchases like flour and sugar would be short-term assets because you’ll use them up once you start to sell inventory.
He says, “If it’s a long-term asset, you might need a financing instrument longer than a year […] At the same time, for short-term assets like inventory, you expect them to sell and be converted to cash, so you typically want to finance that for less than a year.”
Because of these timelines, you might separate your lending into more than one loan so you can nab different terms for each expenditure, says Tonsmeire: “Maybe you look into an equipment lease or find one lender who can finance your equipment purchases, and use another source for inventory and accounts receivable.”
Finally, to really be a responsible borrower, Weiss recommends scrutinizing the default provisions of the contract: “What happens if you fail to make a payment? What kind of cure period do you have to right a wrong? Folks are so excited to get money that they often don’t look at that provision section of the contract.” He also stresses comparing rates from many different companies to find the best one. As with anything else, comparison shopping could save you enormously.
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