Ways to decide taking out loans to start or grow a business

Written by John Paul

These days, loans have a bad reputation among entrepreneurs for several reasons.

One reason is the growing number of 'loan sharks' out there who specifically target and take advantage of entrepreneurs.

Loan sharks are notorious for giving out loans at very high interest rates, and also for their aggressive and brutal recovery tactics.
Six hot spot why some business personal retire poor Another reason loans have a bad reputation is the snobbery of banks.

With most banks, it’s often too difficult for businesses without collateral or a proven transaction history to get bank loans.
I meet a millionaire and he thought me three lesson On top of that, there are several horror stories of entrepreneurs who have lost their business and valuable property due to unpaid loans.

So, are loans just bad for business?

My answer: it depends.

You see, loans can be fertilizer for a business. And they can also be poison.

Loans can significantly help, or ruthlessly kill, a business.

So, the trick is to learn WHEN and HOW to use loans so they can act as fertilizer, and not poison, in your business.

That’s what today’s lesson is all about.

Here’s an excerpt of the email I received that inspired today’s lesson.

It’s from Abdul, a logistics entrepreneur based in Ghana.

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Hi John-Paul,

I own a logistics company that trucks goods, but I’m at a point in my business where I’m stuck.

I started the business several years ago with one truck which I bought with my savings. I now have two trucks in the fleet.

I’m now at a point where it’s getting difficult to serve more customers due to the limited size of my fleet.

I often find myself directing them to competitors when all my trucks are on the road.

I’ve been thinking about taking out a loan to expand the size of my fleet so I can keep my customers. However, I've heard a lot of horror stories about loans.

What do you think? Please advise.

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Thank you for this interesting question, Abdul. I’m sure a lot of people will learn from the advice.

When it comes to loans, there are three important factors that determine if a loan will be fertilizer or poison in a business.

I’ll discuss each of these three factors so you can make the best decision for your business.

The first factor is Risk.

Risk is actually the factor that can quickly make a loan become a poison.

To help you understand what I mean, it’s important to explain the basics of a loan.

Unlike equity investors who may not get anything if a business doesn’t work out, loan providers have to get their money back even if your business fails.

Paying back equity is optional. But repaying a loan is usually mandatory.

Therefore, you should only take a loan for a business that has a good chance of success.

If you take out a loan for a business that is just an idea, a business that does not have any paying customers, or a business that could take a long time before it makes money, that loan could be poison.

In your case, your business already has paying customers and you need funds to expand your capacity to serve your existing customers.

In my opinion, your risk level is quite low -- you already have a tested, proven and successful business (on a small scale).

Also, you have assets (your two existing trucks) that can be used to secure the loan.

Unless your banker is foolish, I don’t see anything that should stop you from getting the loan if you apply for it.

The second factor is Cash flows.

Any business that gets regular and predictable cash flows is a good match for a loan.

That’s because most loans – especially for equipment purchases – usually have a monthly repayment plan.

The problem with a loan starts when you start missing your monthly repayments. That’s when loans can put you in trouble.

From your email, it looks like your trucks are always on the road.

If that’s true, then your business likely gets regular cash inflows from paying customers.

However, what you should really focus on is the net cash flows.

Do you still have any cash left after you take care of expenses for fuel costs, driver salaries, maintenance, repair and all the monthly costs of running your business?

Any cash that remains – the (positive) net cash flow – is what you’ll need to pay the regular loan repayments at the end of the month.

Remember, the earlier you purchase the new truck(s), the more they’ll contribute to the cash flows you already have in the business.

Please make sure that you match the size of the loan to the size of your net cash flows. If you take out a loan that requires you to make monthly repayments that your cash flows cannot support, you could get your entire business in trouble.

The third factor is the Terms of the loan.

All the terms of the loan will be in the loan contract you’ll sign before the bank gives you the money.

The most important term you should look out for is the interest rate.

Is the interest rate on a per-month or per-annum basis?

Remember a 5% monthly interest rate actually means a 60% annual interest rate.

However, a 24% annual interest rate means a 2% monthly interest rate.

Also, are there other fees to be paid besides the interest rate -- such as admin charges, maintenance fees, annual fees, etc.?

The bottom line is to make sure you understand the total cost of the terms you’re agreeing to.

So, to summarize…

The main reason entrepreneurs get into trouble with loans is due to one or more of the factors you’ve just learned.

However optimistic you may be about the prospects of your business, loans can be quite unforgiving and poisonous to high-risk businesses.

Therefore, if your business is in the idea or startup stage, you need to be very careful with loans.

But if your business has paying customers and you’re under pressure to expand to meet the needs of existing (or more) customers, you’re a good match for a loan.

Also, always watch the cash flows.

Cash is totally different from profit.

Cash is real – it’s money in your pocket, till, or bank account.

Profit is imaginary – it’s money you ‘expect’ to make.

Make sure you know the difference because loans are usually paid back with cash and not profits.

And last, you need to understand the terms of the loan you’re getting into.

Pay attention to the total cost. Banks and loan providers often disguise additional costs as fees and charges that are separate from the interest rate.

If you pay attention to all the important factors – risk, cash flows, and terms – you could dramatically transform your business with the powerful leverage loans can provide.