Is now the right time to borrow to grow your business?
Many business owners wonder about the best time to borrow. Should you wait for an idea, a new project, a business opportunity or for interest rates to drop?
A well-planned loan can help leverage and finance your plans for growing your business, even when interest rates are high.
There are several reasons for borrowing. According to Sébastien Machado, Manager, BDC Entrepreneurship Centre, some of these include:
When is the right time to borrow?
“If you have a plan for growing your business and you’ve done your homework, borrow when you have the capacity,” says Machado. “It’s always better to shop for umbrellas when the weather is nice because when it’s not, all the umbrellas are sold out.”
Your borrowing capacity can be determined using the debt service coverage ratio, which is calculated by dividing the company’s EBITDA (earnings before interest, taxes, depreciation and amortization) by the sum of the interest and principal repayments on the current and long-term debt payable over the period (usually one year).
A ratio of more than two is usually healthy and indicates that you are able to meet your obligations.
Other key indicators will also be used by financial institutions to assess your borrowing capacity. These include:
- your personal credit report
- interest coverage ratio (EBITDA divided by interest repayment)
- debt-to-equity ratio
- debt-to-total assets ratio.
You’ll also need to remember that getting a loan may be more difficult during an economic downturn. So, it’s better not to wait for the your business or economic conditions to deteriorate before applying for a loan or a line of credit.
Machado notes that there is really no good or bad time to borrow when you’re well prepared, which is why every company should have a long-term vision.
Should a rise in interest rates affect my decision to borrow?
One of the biggest consequences of an interest rate increase is the reduction in your borrowing capacity, which makes budgeting your projects and ensuring their sustainability that much more important.
Machado offers these three tips to deal with this situation.
1. Keep a closer eye on your finances
If you think interest rates may be on the rise, it might be helpful to perform a sensitivity analysis, i.e., create models that show the effect an increase in interest rates will have on your company’s finances. This will allow you to prepare for a possible increase in borrowing costs.
“It’s always a good idea to seek out financial advice,” Machado says, “but even more so when interest rates are rising. This can be done through an advisory services mandate, as well as through an accounting firm or an advisory committee.”
He adds that an increase in interest rates may force a number of businesses to review their operations to try to find efficiencies. This can help them weather any potential rate changes or other price increases.
He also advises to regularly review the company’s business model and not hesitate to let go of what is not performing as well financially.
2. Keep an eye out for business opportunities
The longer that high interest rates last, the greater the likelihood that new business opportunities will emerge. Companies may sell for less because of downward pressure on business valuation multiples.
“The cost of borrowing is increasing, which requires more planning,” Machado says. “But business owners who do their homework, are patient and have a real long-term plan, will be in a position to move ahead.”
The situation is similar for projects. When fewer offers are on the market, sellers tend to negotiate. That being said, you could try to negotiate a higher balance of the selling price or offer a lower down payment.
3. Diversify your financing sources
Many business owners are aware of the importance of having a diverse customer base and supply chain. However, where financing is concerned, many of them put all their eggs in one basket.
“There’s a real movement out there of people diversifying their financing sources,” Machado explains.
Diversifying your financing sources allows you to access different types of services that are tailored to specific needs and situations. When considering a business loan, don’t just look at the interest rate; look for flexible terms that meet your needs.
How to prepare for a loan
Sébastien Machado offers four tips for preparing for a loan:
1. Become a financial wizard
“The key is financial management,” says Machado.
Business owners wear several hats and may work on projects that involve finance, marketing or human resources. However, if you want to get a business loan, you’ll need to understand basic financial concepts. It’s what helps you answer bankers’ questions and determine whether or not you should borrow.
Machado’s advice is to take courses, read blogs and articles, and consult specialists in order to become a financial wizard.
2. Build your personal credit
Personal credit is very important for small and medium-sized businesses. In fact, the smaller the business and the amount requested, the more weight given to personal credit.
Developing healthy credit habits will help you attain more attractive financing terms.
3. Determine your financing needs
A growth plan requires planning. However, business owners are sometimes more reactive than proactive. An unexpected large order or an opportunity to do business abroad will create an urgent need for financing. But rushing doesn’t always maximize your financing options.
One of the golden rules for Machado is to “finance over the short term what is short term and finance over the long term what is long term.”
All too often, he says, business owners will use their cash or an unused line of credit to purchase a new truck or equipment. The room that this long-term purchase uses up on the line of credit is no longer available to finance the company’s operations. He advises that you keep the cash flow for your short-term needs and to support your business growth.
“It’s often better to use a line of credit for expenses that can be paid off quickly. Aligning financing and projects by type may sound simple, but it’s important,” says Machado.
Although growth is exciting, you also need to be aware of the associated risks. Growing too quickly can lead to higher production costs, which will affect the company’s profitability or even threaten its survival.
If the company’s sales take off, it might not be able to handle a larger inventory or an increase in receivables. It may then need a line of credit to meet its cash flow needs.
Even if you want to finance your growth and apply for a working capital loan, it will be up to the lender to determine whether your line of credit can be optimized. Even if there is still room on the line of credit, the limit should be increased right away. That way, you’ll have access to the line of credit for shorter-term needs and won’t pay interest until you use that portion. The line of credit can then be supplemented with other loans for longer-term projects.
By determining whether your need is long term or very short term, you may even realize that you don’t need a loan.
The choice to use the line of credit or term loan will also depend on what is being financed.
4. Do your calculations
When applying for a bank loan, you need to show that you’re up to speed on all aspects of the application, such as the costs and benefits of your project.
Let’s use the example of a manufacturer wanting to purchase equipment and expects an increase in sales of $200,000. The manufacturer needs to consider a number of issues.
- Is the contract recurring?
- Will the sales potential still be there next year?
- Is there enough staff to operate the new piece of equipment?
Focussing too closely on what needs to be financed without considering the overall picture of the project or business is a common mistake and should be avoided.
Not sure where to start? Best to contact your bank beforehand to get a better idea of their expectations and the criteria they will use.
Be sure to make use of your network. There are likely some business owners you know who have already been in the same situation. Their advice can help you avoid the usual pitfalls and to be well prepared.
Tackle your company’s finances and find out how to improve your business cycle by downloading Taking Control of Your Cash Flow, a free guide for entrepreneurs.