4 Reasons a Small Business Should Avoid Borrowing

Kris Henry

By Kris Henry, Director of Operations, Troy Business Group

As a small business owner, you understand there are times when cash is short. Loans are available, but many owners don’t know when the appropriate time is to apply for one. And some businesses shy away from borrowing, thinking they don’t qualify when there actually are plenty of opportunities.

Other businesses are quick to apply for loans for the wrong reasons or at the wrong time. In all situations, it is important to understand there are good reasons to take out a loan and then there are bad — and even worse — reasons to do so.

When Not to Borrow

Here are four reasons not to take out a loan:

1. A business has tiny margins. A healthy bank account balance offers a sense of comfort and a loan can give your business a ready amount of cash, an enticing prospect for most business owners. But, loans are an additional cost that you must repay, and that includes the interest.

If your margins cannot afford that additional cost, that’s a horrible reason to take out a loan. For example, if your business model is a restaurant where the cost of making a pizza is $3 and you sell the pizza for $12, then it makes sense to take a loan.

However, if your business model is based on buying paper at $1 and selling it for $1.15, the additional cost of the loan will cause you to lose money.

2. A small business loan for structural flaws. Small businesses often establish their organizational structure organically as the company grows. At some point, the business plan needs to change to match the business. If a business doesn’t change its structure accurately, there will be flaws that cause loss of money.

This is one of the worst times to take out a small business loan. Taking out a loan to cover shortfalls in revenue based on a bad business plan only digs the hole deeper, especially when it comes time for repayment.

While it seems like a good idea to get some extra cash if you are restructuring, revenue sources can be questionable at this time — especially if you don’t have a new business plan laid out for new revenue.

3. Needing to pay off other debts. It can be enticing to take out a small business loan to consolidate debts or to pay off other loans. It may be a case of a dried-up revenue stream or highly leveraged assets. Or, for some businesses, there was mismanagement of finances.

This rarely works in your favor. When a business finds itself in this situation, the first impulse is to pay off debts first and then figure out budgets and revenue. However, another loan only adds to expenses without correcting the primary problem.

Also, a business that finds itself in this situation may not have …

… the best credit due to late payments or overextension. Bad credit puts you at risk for only being eligible to use less-than-ethical lenders who charge high interest rates, a move which digs a deeper debt hole and leaves you with your assets or house at risk.

4. Retaining staff during slow periods. The final entry in the worst times to take out a small business loan is to cover payroll during the off-season. While it’s enticing not to have to go through the cycle of hiring and firing, the situation can lend itself to an increasing debt load as you rely on outside funds for cash shortages.

Although a small business loan at this time is a bad idea for a new business, you can be successful with this plan if your business has a well-defined sales cycle. However, you must be confident on repayment in the busy season without harming margins in the long term.

When Borrowing Makes Sense

Although there are reasons for a business not to take out a loan, there are reasons a small business should take one. Small business loans are ideal for growth, expansion or to cover specific spending, such as inventory before a busy season. These three reasons are the primary ones you should take the plunge and see a bank manager.

Before taking out a loan for any reason, follow this general rule of thumb: There should be a 3:1 correlation for what you can make on the borrowed money versus what you will pay for the money borrowed. If you cannot make twice the amount in profits after paying off the loan, you should avoid getting one.

Kris Henry is the director of operations and principal at Troy Business Group, a small and midsized business funding organization and consultancy headquartered in Miami. Follow @troybusinessgrp on Twitter or Henry on LinkedIn.