For many, the conventional wisdom is that you can never ask for too much money when getting a business loan.
But that isn't always true—a company can request too high an amount and not qualify for that level of a loan. Or, they get that loan but don't have the cash flow from current sales to pay it back.
In my opinion, it's much better to determine how much money you really need first before even applying. You can determine that by asking the following questions before getting a business loan:
1. What will the loan be used for?
This is a critical question to answer because it will affect all the other parameters.
I believe a business loan should typically be used to fund the purchase of equipment or launch a new product or service. I would advise against using it to fund ongoing losses where the loan proceeds will not increase profit in the future. (For example, a company borrowing $100,000 to launch a new product that will take 10 months before it starts to generate $10,000/month to cover its cost.)
Explore loan options. Do you need a loan to manage seasonality, pay for renovations or consolidate business credit card debt? Be sure to compare offering and determine what is best for you.
2. When do you need the money?
Many funding sources can take months to decide on when they can provide the cash for a committed loan.
You need to determine if this will work with the timing of when the capital is needed for the planned project. It's not effective to get money in November if the capital is needed in February.
On the other hand, some flexible term loans enable business owners to pay specific individual invoices. Some loans offer the ability to send funds directly to vendors in as little as two days.
It's important to project cash-flow needs over the next three years before determining the size of the loan you need now.
3. How much will it cost?
When getting a business loan, interest fees can range from the prime rate to upwards of 50 percent, depending on the type of lender and the period of the loan.
You can check your payments by using a simple loan calculator with the amount that is borrowed along with the interest rate. (Bankrate and Shopify are just two of the many options available.)
And don't forget the other closing costs the funding source may charge.
4. How long do you need the money for?
This question is connected to the same one the funding source will be asking you: How long will it take to pay the loan back?
I believe this is where every company needs to put together a simply financial model on a timetable of when the funded project will generate positive cash flow. Meanwhile, subtract the future loan payments from the company's current profit to determine if it can support the repayment before the new project starts to show a return on its investment.
Let's say a company borrows $500,000 at an 8 percent interest rate for a $6,000 payment per month. Can their current profit repay it at this rate? That company's owners could do an additional test by reducing the expected profit by 25 percent to see if they could still meet their repayment obligation.
5. How much can you afford?
Funding sources will evaluate a company's available cash flow to determine if it can pay back the loan. This is called the debt service coverage ratio (DSCR).
To calculate your DSCR, you need to know your annual cash flow profit and the monthly payment amount of the loan.
Some funding sources look at any shareholders' credit score who owns more than 20 percent of the company as part of an additional personal guarantee.
And funders may also review shareholders' personal debt to income ratio (DTI). This calculates their total monthly income to their monthly debt. Many funding sources want the borrowers' personal debt to be no more than 3 percent of monthly income after taxes.
6. What are your future financing needs?
After getting a business loan, will your company need future financing to support growth?
Some companies take out the maximum they can afford now, but it still isn't enough to fund the company's future expansion because revenue goals can lag. This then leaves them without the necessary cash to grow their company.
It's important to project cash-flow needs over the next three years before determining the size of the loan you need now.
Consider exploring unsecured loans with flexible lines of credit that can be used for consolidating business card debt, fund inventory purchases, expand operations or increase working capital.
When getting a business loan, my advice is to always try to apply for 10-20 percent more than the company really needs if you can qualify for the higher amount. Many times expenses are either more than anticipated or revenue takes longer to generate than expected.
Read more articles on financing.
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