You're a small business owner. You understand that bootstrapping is holding you back and you're leaving a lot of money on the table, so you decide to finance your next project. But you're not sure if debt is the best option (why not equity? Or crowdfunding?). You're not alone. And to be honest, debt is not always the best financing tool for your business. So what's the appropriate use case for a business loan? More importantly, what's the wrong use case for debt?
Here's the test we propose for whether to take on debt:
- The reasonably expected return on your investment must be greater than the APR
- The debt must be affordable out of current or reasonably expected future cash flows.
If the answers to both of those question is "yes", then debt is a good instrument. If the answer to the first is "no" but the answer to the second is "yes," debt might not be advisable. If the answer to both is "no," you should pursue other options.
Let's unpack that in parts.
Is the Expected Return on Your Investment Greater than the APR?
The first question to ask yourself in deciding whether to take out a business loan is whether the $1 you spend today will generate a return that is higher than the cost of your debt, typically denoted as APR. If so, that might be the appropriate use case for debt. If not, you either need to find a cheaper source of debt—or if no cheaper source is available, another financing option.
So, for instance, if you borrow $10,000 today at a 50% APR, and you expect to earn a 75% annual return, your expected return is greater than the cost of your debt. So that might be an appropriate use of debt.
On the other hand, if you borrow $10,000 today at a 100% APR, but everything else remains the same, that's probably not the best use for debt. At the end of one year, you'd be poorer than if you never took on the debt in the first place. So you'd need to find cheaper debt.
The test gets a little more complex with things like emergency replacements of key equipment (e.g., your pizza oven—assuming you're a pizza parlor of course). But it's basically the same. You ask "How much am I losing every day I don't replace this equipment?" Then you calculate "How much will this loan cost me every day in interest?" If the amount you'll lose is greater than the interest you'll pay on your debt, then it's a potentially good use case. (Hint: replacing key equipment is almost always a good use case).
So the first test is to ask whether the reasonably expected return is greater than the APR. Obviously, in order to perform this test, you need to know the APR of your debt (another great reason to always know your APR!). Our APR calculator works for most types of debt, and other calculators abound on the Internet.
But you also need to know the reasonably expected return on your investment, and this is where many business owners run into trouble. Debt isn't a great instrument for highly speculative ventures, because you can't calculate the return on investment (and therefore can't determine if it exceeds the APR).
Is the Debt Affordable Out of Current or Reasonably Expected Future Cash Flows?
The second question to ask yourself in deciding whether to take out a business loan is whether you can afford the loan payment, i.e., is the debt affordable? Debt can be affordable in one of two ways.
The present affordability test
The first way debt can be affordable is if you can afford to pay it from your current operating income. If your operating income is greater than your debt payments, then congratulations: you can afford that debt—assuming nothing else goes wrong. But just in case someone does go wrong, most lenders (and prudent borrowers) want to see a little padding. Most traditional small business lenders want your operating income to be at least 25% greater than our debt payments. This measure is called your debt service coverage ratio.
Note also that debt might also be affordable if you could afford to pay it out of your current operating income if you wanted to. High-growth companies are typically cash-flow negative by choice. They're reinvesting every dollar they earn back into the business. But if worse comes to worse, they can dial back the growth and become profitable in short order (though this is typically an unpleasant experience).
Those companies can, in effect, afford the loan if (and only if) they would have sufficient operating income to have a debt service coverage ratio above 1.0 but for their growth spending.
The future affordability test
The second way debt can be affordable is if you can afford to pay it out of reasonably expected future operating income. For instance, if every $1 you spend in inventory yields $2 in profit, then taking on a $100,000 inventory loan will be affordable, at least insofar as you can repay it out of the $200,000 you reasonably expect to earn in profit.
But note that the key phrase here is "reasonably expected." Unless you can afford to make payments even if things goes wrong, speculative projects are not a good use case for debt. Save those for venture capitalists.
Note also that this reasonably expected future operating income needs to be realized in time to make your debt payments—or you need cash on hand to make the interim debt payments. So, for instance, if you invest $100,000 on Day 1 with the expectation that it'll earn $300,000 on Day 90, make sure you have money in the bank to make your loan payments on Day 31 and Day 61 (and frankly, Day 91 because nothing ever happens on time).
Pro Tip: Monthly Payment Matters... a Lot
APR is important, not least because it tells you what sort of lender you're dealing with, but it's not the only thing to consider.
But assuming the return on investment is greater than the APR, it's a "good" investment no matter what the rate (though still definitely worth shopping around!)... at least according to your CFO.
Your payment, on the other hand, determines the affordability of the loan in absolute terms. And the biggest driver of payment amount is loan term. Unless the APRs are wildly different, a six month loan is going to be about 10 times less affordable than a five year loan. So don't foolishly take on an unaffordable monthly payment chasing after a "low" APR if it means taking on a short term loan.
So what about some concrete examples? Let's walk through a few.
"Should I use a loan to start my new business?"
Mark Cuban says no. We say... maybe. The SBA will guarantee startup loans, and the most conservative financial institutions (banks) will sometimes make them, so that suggests they're not all bad.
The real question is whether they pass the debt test. First, ask whether the reasonably expected return is greater than the APR. If you can't calculate the reasonably expected return with a high degree of accuracy, then you can't price the debt, and therefore you probably shouldn't be using it. But if you've got a pretty good idea of what the return will be (maybe you've done it before or it's a highly proven business model), and the reasonably expected return is greater than the APR, then you should address affordability.
This is where a lot of startup loans run into problems. No matter how awesome your new business is, it probably won't generate a ton of revenue in the first few months, meaning you'll struggle to service your debt. The two ways to avoid this problem are (1) start with a period of no payments or interest only payments, or (2) take out more than you need and service the debt out of the loan monies. If this describes you, check out our Able Start product, where you can create your own payment schedule.
Note: If you're thinking about using debt to start a highly speculative venture that relies on an unproven business model (the Uber of Facebook or something silly like that), the answer is always going to be "No." Why? Because you have no idea what your future revenues are going to look like. So you'd fail both the first and the second prong of the test.
"Should I use a loan to reduce my costs?"
Cost reduction in a well-established process is a nearly perfect use case for debt.
What's cost reduction? It's when you have a known cost in your business model (e.g., inventory purchasing, high-interest debt payments) that you can significantly reduce using debt (e.g., by buying in bulk, by reducing high-interest debt payments). Assuming you can reduce costs by more than the APR of the loan, then this is a clear use case for debt... assuming of course it's affordable!
"Should I use a loan to expand my production?"
Expansion loans are very much dependent upon how they get used. And here's where the test is really helpful.So first ask yourself, is the return on my investment reasonably expected? Investing in things like purchase orders and new contracts are great, because they're very likely to yield returns. Things like opening new markets or product lines are less so... if you aren't sure the expansion will work out, then make sure you can afford the debt with your current operating revenue.
Next calculate whether the expected return is greater than the APR. If so, then you'll need to assess affordability. If not, you need to find a cheaper loan.
"Should I use a loan to open a new location?"
Here the answer is a bit more mixed. Your new location isn't guaranteed to do as well as your old location. In fact your new location isn't guaranteed to open at all (you might, e.g., run into permitting issues). So don't put on your entrepreneur-colored glasses and assume you'll be able to pay for the second location out of that location's operating income. That might be possible down the line, but in the interim you'll likely be servicing the debt out of your current location's operating income. If you can do that, then debt might be a good vehicle. If you can't, you should probably consider equity.
The Importance of Underwriting
At Able, one of our core commitments to borrowers is to never give them a loan that we don't think they can afford. That means we have to reject some applications (and forgo a big chunk of revenue!), but it also means we can sign the Small Business Borrowers Bill of Rights.
We do that because we don't want to saddle you with debt you can't afford. That doesn't help us, it doesn't help our capital providers, and it doesn't help you.
Among other things, the job of our underwriting team is to assess whether debt is the best financing tool for your needs—and particularly whether it's affordable. About half the time, it's not affordable (i.e., a borrower's debt service coverage ratio is too low and the proposed loan use isn't likely to generate substantial new revenue).
This probably doesn't take the sting out of a loan rejection, but it might help put it in context—and maybe make you think before trying to find another lender that will given you a loan, knowing you can't afford it.