Maintaining a small business is no mean feat, especially when that business has to adapt to growth opportunities and unexpected challenges. To guarantee the continued survival of your enterprise, you need to do what you can to overcome the hurdles. Often, this means applying for external finance, either to help you to reach your growth ambitions or to fill a deficit in your operations.
Debt finance, as the most traditional form of external funding, is usually the first place small businesses turn to. And why not? Many companies will probably have been with the same bank for years, making it easier to obtain a loan. You borrow the amount you need and pay it back, with interest, in the form of manageable instalments.
While debt finance, when used correctly and considerately, is a great way to give your company the support it needs, it is also essential to be careful. You must remember you are taking on debt – which means entering an agreement to make regular payments, or risk entering an unpleasant financial situation.
In this blog, we have detailed the common pitfalls you should avoid when seeking debt funding, so you can make sure you identify the right solution for you and ensure the success of your SME.
- Borrowing more than you can afford
- Becoming dependent on financing
- Taking the wrong type of finance
- Not keeping up with repayments
- Not shopping around for the best offer
Borrowing more than you can afford
A new-found enthusiasm for finance may mean that your instinct is to go out there and borrow as much as you can. Sometimes lenders will surprise you and offer more than you expected. However, while a large sum of money may seem exciting at first, it can harm your business.
The more you borrow, the more you need to pay back – and the more interest you will be paying as a result. Without an explicit reason for the unnecessary additional funds, you could be overpaying for the privilege. It is therefore vital to only borrow what you can afford to repay every month and make sure that you shop around to get the best rates.
Ahead of seeking finance, understand what your funding needs are and how much you wish to borrow. Use this figure as a ballpark and do not be tempted to borrow more than you need to – as you’ll be paying interest on every penny that you don’t need as well as that which you do.
Similarly, do not be tempted to borrow several loans to get as much funding as possible. Instead, focus on getting one loan that covers your needs where possible. You’ll build up a better credit rating by paying off one loan before seeking another and also won’t be paying interest across a number of different loans invariably at vastly different rates. Instead, plan your funding requirements in advance and borrow on a need-to-lend basis.
Becoming dependent on financing
Whilst it is vital to utilise funding whenever you need it, do not make the current need for finance into something your business comes to rely upon.
You can look into this yourself using a metric known as your debt-to-equity ratio. This will analyse how much money you have invested in your business and how much revenue you’ve brought in, relative to the amount of debt you are currently carrying. The resulting ratio will highlight how self-dependent your company is, and whether or not it is too reliant on borrowings.
Remember that finance should be a support tool rather than the lifeblood of your company. It should be used to enable the growth and survival of your business, so that you can begin generating profit. It should not replace your revenue.
If you feel that you are becoming over-reliant on external funding, it may be worth looking at your business model and financial plan in more detail to uncover where the faults may be. You may also wish to consult with an impartial advisor who can help you to understand the best options for you.
Taking the wrong type of finance
Businesses that seek finance are likely to have a specific need for the funding. It could be to plug a short-term cashflow gap or fund the cost of a new employee. Either way, you need to be clear about the best finance solution to meet your requirements. Understanding the different sources of debt funding that are available to you, and the implications of each will empower you to make an informed decision about what is the right route for you.
Short-term loans provide a quick fix solution to a funding challenge in return for higher interest rates and limited repayment terms. You’re clear of the debt in a shorter space of time, but it will impact your monthly balance sheet. As such, these tend to be favoured when there is an urgent cash issue in the business, or a smaller amount of funding is required.
Long-term loans are used to fund more substantial growth aspirations and require a good credit-rating (and business plan) for approval. They come with lower interest rates over a more flexible period, making them more affordable in the long run. You must remember that these loans can often last years, so you need to be confident you will be able to meet repayments and clear the balance in the designated timeframe.
Of course, you don’t always need look at a loan either. If you’ve got a good order book and are simply short on cash to deliver the service, invoice factoring and discounting or trade finance can be great ways to unlock the cash tied up in your sales invoice values. These cash flow management options also tend to be short-term and quick, which many enterprises will welcome.
You may even consider equity funding as an alternative to debt, if you are willing to offer shares in your company.
Researching your options in advance will enable you to find the most appropriate solution for you, aligned with the unique challenges you are facing. In turn, this will help you to get the most from any funding you receive and increases your chances of success.
Not keeping up with repayments
Fear of debt is one of the main reasons why businesses try to avoid external finance. Missing a repayment and subsequently getting behind on future payments means your borrowing suddenly becomes a whole lot more expensive, causing a dent in your cashflow courtesy of late-payment penalties and fees. It will also affect your credit score meaning that any future attempts to secure investment, debt or equity, could be hindered.
To avoid getting into a scenario where your debt snowballs, it is essential to understand what you can afford before you commit to any form of finance. For example, your loan repayments plus your outgoing costs should not be greater than your income each month. Check your accounts and make sure that you have the room to start incorporating a loan repayment plan.
This also means carefully reviewing the small print before you sign up to a loan to make sure there are no hidden fees that may go beyond your means.
You should have contingency plans for when things do not go according to plan and threaten your ability to make repayment. If you are using the loan to achieve a certain objective that you hope will boost revenue, what will happen if profit doesn’t rise the way you expect it to? What happens if another unexpected event harms your finances or disrupts demand? Even if the chances are slim, preparing for the worst will enable you to have survival strategies ready and assist you in repaying your debts.
Not shopping around for the best offer
Most businesses faced with a financial challenge are likely to favour familiar advice, turning to a friend, local provider or recommended adviser. They also turn to the good old faithful bank. But this doesn’t always deliver the most competitive solution. Sourcing funding should be a commercial decision rather than an emotional one.
The best situation you can create is one where lenders are in competition with one another for your business. In the modern lending market, there are more options than ever for companies to consider, with traditional and alternative lenders each offering their own advantages to those who take out a loan with them.
Your chances of securing the best rate on the most competitive terms will increase hugely when there is more than one finance provider vying for your business. External finance has a value and you need to make sure you aren’t overpaying for it.
To find the best deal, you need to spend time shopping around and weighing up the many potential paths for your enterprise. Compare things like interest rates, loan lengths, additional benefits and so on to determine which lender comes out on top. By doing so, you could end up with a better deal than you may have got just by heading to your bank.
In summary
Debt finance solutions are a great option for businesses seeking funding. The key is in the preparation. Regardless of the funding type you opt for, or the amount you choose to borrow, you need to be in full control of your business’ finances and long-term strategic position.
Without this, you will be deemed as a higher risk, making it difficult for lenders to see the long-term potential of your business proposition. You need to go into the funding process armed with knowledge which will increase your chances of getting finance whilst avoiding the common pitfalls.
By understanding the potential traps, you will be able to find a funding solution that is tailor-made for you, allowing you to utilise financial support when you need as well as fuel the long-term success of your enterprise moving forward.
If you need help in determining the best debt finance option for you or seeing what is available, our team of advisors can help.