Small business owners can access capital through small business loans to help grow their business. But for their business to grow owners need to understand the right ways and the wrong ways to use debt.
Five good ways to use small business lending
Five good reasons to take out a small business loan include:
- Buying another business – buying another business provides the opportunity to quickly grow your existing business through the acquisition of another company.
You should evaluate the potential earnings of that business prior to acquisition, including preparing projections for future cash flow and ensuring that the increase in cash flow and net income exceeds the potential future loan payments.
- Buying productive equipment – acquiring equipment that increases your business’s capacity and ability to scale can result in increased revenue and gross profit margin and is a great way to use small business lending.
You should develop a good understanding of how that equipment will positively impact your company’s revenue generating potential by increasing efficiency or productivity prior to making a purchase.
- Investing in advertising and promotion – taking out a loan to pay for advertising and promotion can increase sales and profit.
We recommend that you use a long-term loan to pay for advertising and promotion that has a long-term or perpetual benefit like building a new website that will generate revenue for years to come or developing relationships with repeat customers that will continue to purchase your products or services for many years in the future.
- Hiring revenue generating employees – revenue generating employees are one of the most significant ways that a small business can increase its productive capacity and potential revenue. But every newly hired employee requires time for onboarding and training before they can become productive in their role.
A working capital loan can provide the cash needed to stabilize a business while you train this new person to begin generating sales and profits.
- Buying inventory – a short term loan can provide the financing required to increase your inventory on hand.
Inventory loans should be repaid as quickly as possible using proceeds from the sales of the inventory that the loan was taken to purchase. Gross profits from the sale of that inventory should then be used to buy additional inventory without the need for an additional loan.
Eventually your business should be able to purchase all of its inventory through the cash flow generated from its sales.
Three bad ways to use small business lending
Reasons not to get a loan include:
- Operating costs – small business owners should avoid taking out a loan to pay for operating costs like paying bills or trade payables, rent or mortgage payments, or current expenses.
Small business owners who use loans to provide cash for operating costs often don’t recognize that the loan doesn’t solve the problem - the loan just defers the problem for six months to a year until the loan funds are exhausted.
Later those same structural problems that caused the small business to fall behind on current expenses still exist but now with the addition of fixed loan payments on top.
- Other loan payments – using a small business loan to fund payments on other loans might be the worst way to use lending.
If a business is struggling to make loan payments a small business owner compounds the problem by taking out debts to use to pay other debts.
Eventually that business owner can’t make the debt payments and may find themselves in a situation where they are forced to default on their loans effectively ending the business.
- Tax payments – small business owners should not take out a loan to pay off tax debts.
Canada Revenue Agency is a low-cost lender and charges interest at a rate of only 6% per year.
Small business owners should plan to pay off tax debt with future cash flow from the business as well as ensure that they do not fall behind on new tax debt arising from future sales and operations.
The fundamental difference between the “good lending” and the “bad lending” described above is that good lending is used to make investments in the long-term growth of your company whereas bad lending is used to pay for expenses that have no residual value after the loan funds have been used to make payments.
If you are considering taking out a small business loan for your company you should consult with one of our accountants to make sure that a loan makes sense for your business and will help you to scale and grow your company.
