4 Questions to Answer Before Taking a Small Business Loan

  • By The Able Team
  • Published 12/17/2016

There’s a ton of information about small business loans on the Internet. But the problem for most small business owners is (1) they don’t have a lot of time to research small business loan options, and (2) they don’t know where to start.

“Everything You Need to Know About APR” can give helpful answers to things like “What is APR?” and “How is APR calculated.” That’s helpful, but only if you already know what questions to.

This blog post will help you figure out what sort of questions you need to ask. By the end of it, you should have a clearer idea of what sort of questions you should be asking, as well as point you to guides that will help you answer them.

Should I Get a Loan?

This may seem simple, but the first question you should ask in researching your small business loan options is “Should I get a loan?” Put differently, you should ask whether debt is the right financing option for your needs.

Debt is not right for every situation. Sometimes equity is the best option, as for instance if you’re engaging in a highly speculative venture with the possibility of large returns but a high probability of failure, such as a startup.

So when you should take a small business loan?

You’ll want to use debt in two primary cases. First, if you have a project with a clear return on investment. Second, if you have strong but lumping cash flows and you want to ensure sufficient cash on hand to avoid a cash crunch.

For a more through treatment of whether to take out a small business loan, you can start here.

Can I afford it?

Another seemingly obvious question is whether you can afford debt, and if so, how much.

Unlike equity, debt typically must be repaid on a fixed or predefined schedule… regardless of how much money you have. If you take out more than you can afford to repay, you’ll end up missing your payment and defaulting on your loan, with stiff consequences.

So how do you determine how much you can afford?

You can figure this out by calculating your debt service coverage ratio, which is your yearly net operating income divided by your yearly loan payments.

If you’re hoping to service your small business loan out of your current income, use your current net operating income for the numerator. If you’re hoping to  service your small business loan out of projected future income, use that as the numerator. In either case, the denominator should be your projected yearly debt payments after taking out your small business loan.

For a more thorough treatment of debt service coverage ratio, you can start here.

Is It Worth It?

A related question is whether a small business loan is worth it. Put differently, does your small business loan have a positive return on investment, , do you expect to earn more from investing the money you borrow than you expect to pay in interest?

If you do, then it’s (arguably) a worthwhile investment. If you don’t, then a loan might not be the best financing option.

In order to figure this out, though, you need to know the true cost of capital, which is typically measured as annual percentage rate, or APR. Many lenders go out of their way to hide your true APR, so we recommend using an APR calculator (like Able’s free one) to find out the true cost of your loan.

What Sort of Lender Am I Dealing With?

Not all lenders are the same. Broadly speaking, you’ve got three basic categories:

Banks and SBA Lenders. These are larger institutional lenders. They typically have marble lobbies, very generous rates, and very strict (government-mandated) qualification criteria. They offer great deals, if you can get them—but most businesses can’t.

Alternative Lenders. These are smaller, more nimble, and slightly more expensive versions of larger institutional lenders. They typically run about 3-10 points higher than a bank loan, but they’re much easier to get and move a lot faster. Most are online and leverage technology to offer fast approvals and lower rates.

Speciality Finance. These are companies offering niche products like merchant cash advances, factoring, or asset-based/equipment lending. They typically specialize in only one or two products. Many have been around for decades—others are recent additions. Depending on the company and the products, rates can be a little higher thank a bank (for asset-based/equipment lending) or a lot higher than a bank (30-50+ points higher for MCAs).

You can learn more about each category here.

Am I Getting the Right Product?

Not all financial products are right for all situations. Often, you’ll think you’ll need a small business loan, when in reality you’d be better served by a line of credit. Your basic financing options are:

  • Equity: selling a portion of your company as a way of raising funds. Great for early stage companies and highly speculative ventures.
  • Line of credit: a revolving loan that you can draw down and pay back. Great for smoothing out cash flows and short-term working capital.
  • Credit card: a line of credit that’s typically only used at a point of sale. Good for working capital, but also for convenience.
  • Factoring: the sale of unpaid invoices at a discount, as a cash-flow management tool. Decent working capital solution for B2B companies with invoices but poor/middling credit, but tend to be pricey.
  • Merchant cash advance: an advance of cash in return for a specified percentage of future credit or debt card receipts (or future income more generally). Best used for emergencies, when you needed cash yesterday.
  • Term loan: a standard loan with a fixed term and repayment structure. Good for longer-term projects and larger investments.

Each of these has its pros and cons. You can learn more about them, and their best uses, here.

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