Three Questions To Ask Yourself Before Taking Out A Loan

Updated: Jan 25

Every new business owner will face the question of whether borrowing funds is necessary for their organization to grow. Most would never question this as a necessary, viable means to securing cash, yet I would argue they should question it…and question it hard!

Some time ago, I was asked to participate in an emergency meeting with the leadership team of a small business, which had enjoyed fantastic growth rates over the first few years of business. Now, it was facing a sudden, unexpected drop in sales with no apparent end in sight. In preparation for that meeting, I reviewed their financial statements and learned there were no cash reserves and their debt levels were essentially maxed out. They had absolutely no margin to weather the storm that had only just begun. Fundamentally, they had only one viable option available: cut costs everywhere! Cut expenses, reduce orders and lay off a significant number of employees. It was a painful time and arguably unnecessary. How could it have been different? I believe this can be answered by asking yourself three questions before taking out a loan.

1. Is a loan really necessary?

Most of the time entrepreneurs will borrow money because cash seems to be short when they need it. This can be driven by several different causes and it’s important to understand these reasons before jumping into a loan.

Seasonality – Many businesses are simply seasonal. For that reason, there are times when little cash comes in. Most owners know this intuitively, but don’t understand how to manage this financially. It requires planning and budgeting.

Rapid Growth – This may come as a surprise, but this may be the most frequent business killer of all time. Many business owners pursue all business opportunities, strapping the company with debt and obligations it simply cannot sustain. Look at your growth rate and compare it to others in your industry. Is it 2 – 3 times higher?

Excessive Expenses – When money does come into the business, it is not uncommon for first-time business owners to get sloppy with the money, usually intermixing personal expenses into the business. Look at the finances of your business with a critical eye and you’ll likely find some areas where money is being wasted. An independent perspective of a CPA can be invaluable here.

Stealing – If you have employees, this is always a possibility. Set up financial processes to eliminate the potential for this to take place and always keep an eye on it.

2. What are the dangers of borrowing?

Interest – Is interest really a danger? Maybe not in the physical sense, however, for your business, every dollar paid in interest is wasted money. And wasted money in business is counterproductive to building a healthy organization.

A Bad Idea Compounded – Dave Ramsey notes  in his book, Entreleadership, borrowing money can negatively compound the impact of a really bad idea.  Going “BIG!” on a hunch may work once in a while, but it is not a practice consistent with successful businesses.  Jim Collins, in Great by Choice, shares that the most successful businesses test their ideas thoroughly in small ways (shoot bullets) before they invest heavily in the most successful ideas (fire cannons).

Personal Liability – When you’re a small business owner, particularly a new one; you will be required to sign off on the note personally. In other words, all the hard work you did in setting up your business entity to protect you from creditors does not apply to the bank. Do you want to bear that responsibility?

3. Are there any other options available?

Slow Down – This may be the antithesis to popular business dogma, but one of the best ways to avoid borrowing money is to slow down the growth of your business. Keep it at a manageable pace.

Manage Expenses – Again, planning, budgeting and ongoing monitoring are necessary measures to keep costs under control.

Retained Earnings – This is your business’s savings account. Every dollar that is in retained earnings is money available for your business. When you draw funds out of the business, you reduce your equity in the business in the form of cash. This is a critical concept that many miss. Just as you put money away in savings personally, you should do the same in your business. Challenge yourself over time to build a reserve of 3 to 6 months of operating capital here. Make this a budget item and be faithful to it. It will create financial margin for your business that few businesses experience.

Borrowing money is a controversial topic, but one I think is worthy of discussion for every business owner to really wrestle to the ground. I am applying these principles to my business and my clients, because I believe that no debt is good debt. I would much rather earn interest than pay interest, wouldn’t you?

If you have questions or comments on this article, I welcome a discussion on the topic at the bottom of the blog page.  Don’t forget you can follow and reach me on any one of the social media sites listed below, as well.  Simply press on the preferred button.  If you’d like to schedule a call, please click on this link.

Please join us for the next article in the Where Do I Start? Series, in which we will address the Six Steps To Securing A Loan For Your Business.

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