Taking a loan is one of the fastest ways to inject more working capital into a business and help it expand. However, studies show that nearly a third of small businesses commit one or more business financing pitfalls that lead to their failure within three years of operation. We talked to multiple certified financial planners (CFPs) to find out why the majority of start-ups fail. This is despite them borrowing money to get them off the ground.
The following are five small business loan mistakes you must avoid to minimise risks and costs while maximising results and flexibility.
Borrowing more than your ability to repay
Many small businesses tend to borrow as much money as a lender is willing to provide in an attempt to have a cushion. Asking for more than you can afford to comfortably pay back is a bad decision.
Often, finances are tight when a business is just starting out. This means if you borrow more than your business’s monthly turnover, you risk high-interest payments that could wipe out your profits and revenues. Rather than taking out a huge loan, use your most conservative sales estimates and borrow judiciously.
Applying for the wrong type of loan product
There are very many different types of loan products for small businesses that it’s easy to get confused. The common loan types for SMBs include short-term loans, long-term loans, small business association (SBA) loans, equipment loans, and invoice financing loans. Each of these comes tailored to meet a specific business goal. For example, a short-term loan product helps your business cater to short-term expenses, including obtaining inventory for a bulk order from a new client.
The loan you choose can make or break your company’s financials. So before you apply for a loan, make sure the lender provides the specific business financing that matches your needs.
Not taking business loan protection insurance
Another common mistake that small businesses make is failing to take a business loan protection insurance. When a business borrows any kind of loan, whether from a bank or other financial institutions, they’ll be required to pay back the loan in full. If a key individual like the owner, a partner, or a director passes away or becomes critically ill and unable to continue working, the lender may still ask for the repayment of all outstanding debts.
This is where the business loan protection insurance could spell a lifeline for your company. This policy provides your business with the means to repay outstanding debts if an insured key individual is diagnosed with a critical illness or passes away.
The cover takes care of all types of commercial debts including business loans, overdrafts, directors’ loans, and commercial mortgages.
Borrowing for equipment or inventory you don’t need
Most novice business owners borrow money to acquire the latest equipment, upgrade their inventory, or lease a bigger location. Even though these are smart investments, they’re of no use if you’re getting into debt just to keep the ball rolling on your new endeavour. Keep in mind that when a business is just starting out, nothing’s constant or guaranteed. Everything’s poised to change depending on market conditions and several other factors.
You need to consider every business investment or expense carefully – more so when you’re taking a loan to finance it. Purchasing unwanted equipment or stockpiling too much inventory at once will have a detrimental impact on the cash flow of your business.
Before applying for a loan for any business expense, run the numbers and financial projections to ensure such investments have a good ROI and will actually pay off financially.
Depending on one financial institution
Not shopping around for the best offers can make your small business vulnerable. Not all loan offers are created equal, and it’s important to meet different lenders and consider other financial options before signing any contract.
Make sure you lock in on a lender that offers better loan terms, including smaller closing costs or lower interest rates. Besides, focus on other aspects of the loan such as the amount the lender needs for collateral and how flexible they are on repayment. Do not put your sign over the dotted lines before you fully understand the terms and conditions of the loan. Comparing a few different lenders and their offers is a great way to save money in the long run.
Taking a loan can help to boost the performance of your business if things go according to plan. Even so, before you decide to borrow, make sure you know your company’s financial needs inside and out. Knowing what kind of business loan you need and how much you need to borrow will help you avoid the common mistakes that most small business owners make along the way.