When to take out a loan?

I was recently asked by a small business owner when it’s appropriate to take out a loan. This question is more important than it seems on the surface.

The purpose of external financing is to meet the company’s cash needs beyond its ability to generate cash flow internally. Therefore, the first step is to understand your internal cash flow dynamics and how changes in the business will affect the expected cash availability. What cash will you need and when will you need it? Without this information you could very easily take on debt that is unnecessary or put the company in a position where the debt payments are higher than your ability to pay. Either way you ultimately do long-term damage to the company.

Ideally, you should only take on debt to finance an opportunity in the business. Growth opportunities could be through increasing organic revenue, additional product/service lines, sales & marketing initiatives to improve market penetration, acquisition of another business, etc. Cost reduction actions could result from an equipment purchases for operational efficiencies, implementation of certain operating strategies, staff training or upgrades, etc.

However, you must be careful to avoid falling into the trap of believing your own propaganda and “counting your chickens before they hatch” so to speak. Make sure you know how long it will take to reap the benefits of these actions before you pull the trigger. In my experience it always takes twice as long and costs twice as much as originally thought to do anything. Also, given the difficulties in finding a willing lender and the cost associated with business loans, be sure to have sufficient availability (of cash or loan capacity) in place at the outset to accomplish the desired results. Otherwise, you may be short of cash at a critical stage.

If you find yourself borrowing to fund a stable or static business you must quickly understand the reasons for the funding requirement. The only reasons for a cash shortfall in this situation are short-term seasonal or timing issues, an imbalance in your asset allocation or significant profit leaks in the business.

• If the problem is short-term then make sure you understand the associated dynamics and manage your cash very carefully. This is not the time to spend on unnecessary items. Be sure you can come through the timing issues debt free. Otherwise, there’s something else happening in the business.
• If you find the asset allocation is inappropriate – accounts receivable, inventory, fixed assets are sucking up too much cash – take action to correct the issues as quickly as possible. Depending on the extent of the problem and the market conditions this could take time. Stay focused and diligent. The problems must be corrected for the long-term health of the company.
• If the issue is the result of profit leaks (which always translate into cash problems) you must take action immediately to adjust the business to the current market conditions. Get your expenses in line with revenue until the company’s profits stabilize. Once the company is stable you can then begin to build the business with a careful and balanced approach.

Never borrow to fund a declining business. Although it may provide short-term relief from the pain, you will inevitably dig a deeper hole and most likely be at risk personally for the debt.