While the US economy continues to pick up steam from the Great Recession, businesses are looking for growth capital and as a result, commercial banks are beginning to be IN STYLE once again. If anything we can be sure of both as consumers and producers in the US, business cycles are a given reality that requires wisdom and discipline to foresee and adequately prepare for… but more on this in another article. The focus of this article is on having legitimate and profitable reasons for obtaining a business loan.
In my experience as both a commercial banker and business financing consultant, the “purposes” for obtaining a business loan have been for both ‘good’ and ‘bad’ reasons. First things first, debt capital if not leveraged properly becomes a quick and fast way for any business to go bad. The use of a bank loan for business purposes is not bad; it’s the reason as to why a business owner needs it. In one’s preparation to obtain a business loan, the number one question that deserves a reasonable response is, ” is it an absolute necessity for the business to have this loan?” In other words, in the event the business does not obtain the loan, will this cause any material adverse consequences to the business?
Let’s deal with the first observation: what are the good and bad reasons for obtaining a loan? As stated before, business owners look to get a loan for any and every reason under the sun. Primary reasons I noticed were for lack of positive cash flow and / or refinancing of existing debt which in more situations than not were personal loans used to finance business expenses (notice here that I did not say EXPANSION). Here’s an ironclad rule for having a good reason for obtaining a loan for any business: Ensure that cash flow is positive, stable, and healthy for the foreseeable future. Debt capital is meant to supplement and grow cash flow, not to replace it. If the business is experiencing cash flow problems then the business owners and/or principals need to dig deep and analyze operations and the market… not make the problem WORSE by getting into debt. Next. let’s look at one or two metrics that can help create the right mentality for obtaining a business loan.
The first metric we’ll disclose is the return on equity. For the sake of not getting into any CNBC finance technical jargon, let’s keep it simple: the return on equity metric lets you know whether you are making any money to keep as your own in the business. To calculate, take the profit (if any) remaining after accounting for expenses, and divide this into the amount of money you invested in the business. Expressed as a percentage, the higher the number, the better because it states that the business is a money maker. Also, the ROI metric is a great indicator as to whether the business is cash flowing positively. Remember, profit is nice, but a healthy, positive cash flow IS KING!
The last metric we’ll point out is the debt to equity ratio. Again for sake of simplicity, the debt to equity ratio lets you know how ‘leveraged’ or indebted the business is. To calculate, divide total debt by total equity. The underlying reason this ratio is so powerful is that it ‘forces’ the business owner and/or principals to truly ‘know’ and ‘understand’ the debt and equity that makes up the business capital structure. A fair share of businesses with high debt to equity levels experience marginal cash flow levels due to interest and other mandatory debt payments that are by nature fixed (predetermined repayment schedule). As a take away here, do not incur any unnecessary debt just for the sake of incurring it; have a plan that discloses how the business will not only pay off the debt, but be in a better position financially and operationally after repayment.
In closing, we talked about the importance of having a solid and good reason for obtaining business debt which is to make sure that it’s for legit business purposes and that the business ALREADY has a positive cash flow. Also, we highlighted two powerful metrics to give you added peace in your quest to getting a loan: the return on equity and debt to equity ratio. Aside from the computations that these metrics require, they also ‘force’ one to intuitively ‘know’ and ‘understand’ the risk and stability of the business capital structure in lieu of obtaining debt capital.