Co-founder / Partner at Lendzi.
While small businesses can take on debt for a variety of reasons, the true utility of a loan can be broken down into two main categories: cash flow or growth. Both uses of a loan can be immensely helpful to a business. But as with any type of business investment, taking on debt requires a sound strategy. An asset investment can turn south, so taking on debt can be extremely dangerous for a business. Here’s a look at how companies often use loans for cash flow purposes or use them for growth and the pros and cons of each option.
Using a loan for cash flow purposes
Taking out a small business loan for cash flow purposes is not always the best option, but sometimes it is necessary to fuel the operations of your business. For example, if you have a lot of accounts receivable and need immediate financing to run your business, financing options such as invoice factoring or a cash advance from a merchant can help. So now you get the money you need and you can pay off your short-term financing when you receive your payments.
However, using any type of loan in this way will not yield any real return on your money. It’s true that it can help keep your business afloat during periods of low cash flow, and that’s an important safety raft to have so you can stay in business and generate additional sales and profits. But while it’s easy to write off these types of loans as “the cost of doing business,” using a business loan to actually grow your business can provide better long-term returns.
• Can keep your business running during low cash flow periods.
• Can bridge the gap between generating sales and receiving revenue.
• Can be the cornerstone of your company’s financing strategy, allowing you to operate in all conditions and generate additional sales and profits.
• Can be expensive.
• Does not use your investment to generate exponential profits.
Using a loan for growth
Using a loan for growth can potentially provide a significant return on your investment. While cash flow financing can help keep your business going, a loan used to invest in future growth can get you your money back and potentially increase your profits many times over.
Here’s an example: Let’s say you use a short-term financing option to get your business through until your accounts receivable come in. At the end of the day, your business will still be up and running and you’ll be generating sales and profits, but you’ll end up paying back what you owed plus a little interest. In terms of a direct “investment”, your return will be net negative in this scenario.
But if you took, say, $10,000 and used that money to hire additional salespeople or buy additional inventory, you can get your money back and more. If your additional sellers generate an additional $5,000 in profit, you’ll have a 50% return on your loan investment, minus any interest charges. If your extra inventory translates into an additional $3,000 profit, you’ve made a 30% return on your loan financing (again, minus any interest charges).
• Usually cheaper than short-term cash flow financing.
• Can generate a real return on invested loan proceeds.
• Doesn’t solve any cash flow problems your business may face.
• No guarantee that your investment will provide an adequate return.
How to choose the best strategy for your business
In reality, some businesses will need financing for both cash flow and investment purposes. But the key is to maximize your return on all the money you borrow, for whatever purpose. If your business is profitable enough to self-finance the period between invoicing and payment, then taking out a cash flow loan is unnecessary and your profits could even flow away. Likewise, taking out a more traditional loan and buying equipment you don’t need or expanding too quickly can cost your business money rather than increase profits.
If you’re not sure what’s best for you, it can be helpful to deal with a business loan specialist who can walk you through all the ins and outs of financing. They can help you build a custom solution that can ensure your business is not short of cash flow, nor overlook how taking advantage of a loan can create great business opportunities.
The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice on your specific situation.