Borrowing too little or too late can jeopardize your business

Getting a business loan can be the fuel your company needs to reach the next level of success.

But you have to prepare yourself and your company to get the money and make sure the loan is right for you.

1. Borrowing too late

You may be tempted to finance your expansion projects from your cash flow. But paying for investments with your own money can put undue financial pressure on your growing business. You may find yourself needing to borrow money quickly and doing it from a position of weakness.

When there’s a sense of urgency, it usually indicates to a banker there was poor planning. It’s often harder to access financing when you’re in that position.

Solution—Prepare cash flow projections for the coming year that take into account month-to-month inflows and outflows, plus extraordinary items such as planned investments. Then, visit your banker and discuss your plans and financing needs so you can line up the funding before you need it.

2. Borrowing too little

You’re right to be careful about how much debt you take on. However, low-balling how much a project will cost you can leave your business facing a serious cash crunch when unexpected expenses crop up.

Solution—Develop a cash flow forecast for each individual project including optimistic and pessimistic scenarios. And then borrow enough money to ensure you can cover your project, unforeseen contingencies and the working capital required to bring your project to completion.

3. Focusing too much on the interest rate

The interest rate on your business loan is important, but it’s far from the whole story. Other factors can be just as important, or even more so.

• What loan term is the lender willing to offer?
• What percentage of the cost of your asset is your lender willing to finance?
• What is the lender’s flexibility on repayments? For example, can you pay on a seasonal basis or pay only interest for certain periods?
• What guarantees are being asked from you in the case of default? Do you have to pledge personal assets?

There are qualitative items in a loan agreement you have to think through very carefully. Some entrepreneurs will skim over the loan terms and conditions because they think they’re just legal jargon or standard terms requested by all lenders. But the truth is that terms and conditions can differ greatly between lenders.

Solution—Shop around among financial institutions for the most attractive package, keeping in mind the importance of the terms other than the interest rate.

4. Paying your loan back too fast

Many business owners want to pay back their loans as quickly as possible in an effort to become debt-free. Again, it’s important to reduce debt, but doing so too quickly can cost your business. That’s because you may leave yourself short of cash. Or the extra money you’re devoting to debt reduction might be better spent on profitable growth projects.

Solution—Compare your projected return on investment to how much interest you’re saving by paying down your loan faster than required. If you expect to earn more investing the money in your business, consider slowing down your repayment pace.

5. Failing to keep your financial house in order

It’s all too common for busy entrepreneurs to let record-keeping and other financial chores slide—with potentially disastrous consequences. It’s essential to keep good financial records, including year-end financial statements. Messy financial records can leave you in the dark about how your business is performing until it’s too late to take corrective action. It can also make it difficult to approach a banker for a business loan because not only do you lack documentation, but you’ve also shown a lack of managerial acumen.

Solution—Be diligent about keeping financial records and spend the money to hire an accountant. Also, consider getting help from a consultant who specializes in financial management to get your business on the right track.

6. Making a weak pitch to your banker

You can see how much sense your project makes, but you won’t get far if you can’t persuade your banker to get on board. MacKean says too many entrepreneurs are unable to clearly explain their company’s business plan, past performance, competitive advantages, and proposed project. The result is a polite “no, thanks.”

Solution—Prepare your pitch and practice it repeatedly. Focus on explaining your business and how you’re going to use the money you want to borrow in clear and compelling terms. Remember a big part of your sales job is persuading your banker to have confidence in your management smarts and ability to build a strong business (and pay back the loan).

7. Depending on just one lender

Having a relationship with just one financial institution can limit your options, especially if your business hits a bump in the road. You don’t want one lender holding all the cards should something go wrong. So, just as you would diversify your suppliers or customer base, or your own personal investments, you want to diversify your lending relationships.

Solution—Meet with other lenders and consider using different institutions for different types of financing products.

When does it make (cents) to pay early?

Businesses often offer discounts to customers who pay their bills early. Does it make financial sense to take advantage of these discounts?

The answer is usually yes. They can actually be very lucrative for your business and justify using your extra cash or borrowing to take advantage of them.

But they’re not good for all businesses. Whether they are a good idea for your company depends on a few factors, such as your return on investment, financing costs and cash flow.

Here’s how to figure out whether it’s worth taking a discount for early payment—and whether it makes sense for you to offer one to your own customers.

37% annualized return

Let’s say your supplier offers a 2% discount for paying an invoice in 10 days. Otherwise, the full amount is due in 30 days. This common discount is known as 2/10 net 30.

If you pay in 10 days, it means you’re giving up the use of your money for 20 days in exchange for 2% off. A 2% return over 20 days turns out to be pretty impressive. It works out to a 37% return when annualized.

Even a 1%/10 net 30 discount works out to an 18% return when annualized.

Right for your business?

But the discounts aren’t always worth taking. You have to weigh them against your return on investment, cost of financing and cash flow.

If you earn less than 37% from an investment in your business or pay less to service your debt, you’re best off taking a 2%/10 net 30 discount.

But if your investment return is above 37% (which can be the case especially for some start-ups), then taking the discount doesn’t make financial sense. You could earn more putting the money to work in your business.

Similarly, in the unlikely event that your cost of financing is above 37%, taking the discount isn’t a good idea. You’re better off paying down your debt.

Cash flow is another important consideration. If cash on hand is tight, you should take a pass, even if your financing cost or investment return is above 37%.

When to offer a discount

What about offering early-payment discounts to your own customers? The math works in reverse and that means offering them is very costly.

Your own return on investment or financing cost would have to be above 37% for it to make sense to offer a 2%/10 net 30 discount on an invoice. It would have to be above 18% for it to make sense to offer a 1%/10 net 30 discount.

Thus, unless your business is experiencing cash flow problems or the return on investment of the business is very high, it’s probably not a good idea to offer a discount for early payment.

Probably not worth it

If your customer is paying you within 30 days, it most likely doesn’t make sense from a financial point of view. If you decide to stop giving discounts, it might encourage your customers to start paying late.