If you’re considering applying for a business loan, there are several important questions you need to answer first. Read on.
1. Why does my business need finance?
There are many reasons why you may need finance for your business, such as:
- To give you extra working capital in case you run into cash flow difficulties. Since cash flow issues are the primary reason for business failure, arranging a finance facility can provide an invaluable buffer and keep your business running smoothly as you grow.
- To finance the purchase of essential equipment or technology in order to keep your business competitive.
- So that you can invest in growth opportunities – e.g. acquiring a competitor, supplier or customer; moving into bigger premises; hiring more staff; purchasing extra equipment, vehicles or inventory.
2. Why do I need a business plan for pitching lenders?
Your reason for seeking a loan will dictate which type of finance is right for you. So, the first step in applying for a loan is to prepare a business case, to document how you plan to use the funds and explore whether borrowing is the right decision.
There are always costs associated with business finance…
…and you’ll need to evaluate whether the benefit you gain from borrowing will outweigh those costs. As well as the interest you’ll pay on your loan there may be set-up fees, one-off or ongoing administrative charges and other costs such as charges per transaction or transfer.
A rise in interest rates could have a significant impact on the affordability of your finance, so be sure to factor that in to your projections.
When you apply for a loan, the most important criterion your lender will use to decide if, and how much, they are willing to lend to you is capacity (i.e. do you generate enough clear profits, after all your fixed and variable costs, to cover the repayments on your loan). Although the lender will use their own formula to assess your application, it’s vital that you perform your own calculations first, to establish how much you can realistically afford to borrow without leaving your business at risk of a cash flow crisis.
Borrowing for growth is risky
Borrowing to finance growth can be a risky strategy and is another major reason for the failure of small businesses. Remember that turnover doesn’t equal profits – and that profits on paper are irrelevant if you don’t have cash in the bank when your bills fall due.
Bigger operations may mean extra labour, stock handling, storage and transport costs, while integrating operations following an acquisition can be both expensive and complicated. Unfortunately, it can take far longer than expected to generate enough extra profits to cover the up-front costs of expansion, and meanwhile you’ll have to cover the repayments on your new loan.
If you conclude that your business will benefit from a loan, the next step is to decide what type of finance you need.
3. What type of business loan do I need?
There is one key rule when it comes to choosing finance: match the term of the loan with your business need.
So, for example, if your goal is to have extra cash on hand when you need it ,to boost your working capital, you need a short-term, at-call facility like a line of credit or a business credit card. This will give you the flexibility to access, repay and redraw funds when you need them, while only paying interest on the funds you need.
However, if you’re planning to buy equipment or expand your business, you’ll need longer term finance like a business loan, which you can pay back over time. This is crucial, because shorter-term finance is generally more expensive and may be withdrawn at any time.
4. Secured or unsecured?
The cost of finance is always linked to the risk, so unsecured finance will be more expensive than a secured loan. However, even if your business has assets to offer as collateral, you may still struggle to get a secured loan from a traditional lender.
Banks are well known for being risk-averse, and generally only well-established businesses with excellent credit ratings are successful in applying for a bank business loan. What’s more, the bank application process is generally slow and complicated – expect to be asked for extensive supporting documentation including full financial statements and strategic plans.
For this reason, many businesses turn to the alternative finance market instead. An unsecured loan from an alternative lender is likely to be a more expensive option (and pay close attention to the terms and conditions as they are not regulated in the same way as banks in Australia). But Fintech lenders tend to be far more accessible, easier to deal with and much quicker at assessing loan applications (sometimes giving on-the-spot approval to an online application).