A love of accounting is probably not the primary reason most entrepreneurs decide to start a business, but most of us would agree that at least a basic understanding of good accounting and bookkeeping practices is an important part of running a business. Likewise, mastering the ins-and-outs of financing is important if your business relies on borrowing to fuel growth or fund working capital needs.

Although there are more financing options available today than ever before, it’s important to understand some of the basics of small business borrowing so you can make informed decisions for your business.

Regardless of the particular loan or the particular lender, here are two things you need to consider when evaluating any financing options:

How much does the borrowed capital cost?

Loan costs will vary from lender to lender and, depending upon the loan type, repayment terms can range from a few months to several years. All will impact the cost of the funds you borrow. As a rule of thumb, a shorter-term loan of six months will likely have a lower overall dollar cost than a loan of several years, but the periodic payments will be higher. It is therefore important to understand how the length of the loan term impacts overall cost and the size of the periodic payment.

Most of us are familiar with how to think about a mortgage or an auto loan. Determining the right fit for a business loan, however, is a little bit different and may be more complicated.

Consider the scenario where you’re borrowing to purchase inventory. The cost of borrowed money could potentially impact the profitability of the inventory you’re purchasing. For example, if you plan to turn over the inventory in a relatively short period of time, you may be better off paying less interest and a higher periodic payment over a few months rather than several years. More specifically, if the accumulated interest on $10,000 of inventory is $4,800 on a loan with a term of four years and your margin is 50 per cent (or $5,000 in profit), that particular loan might not be a good fit if you can get the same $10,000 for $1,500 in cost on a shorter-term loan. That’s why, in terms of a business loan, it makes sense to consider the total loan dollar cost when comparing one loan to another and assessing whether the loan fits the particular business use or need.

 

Do you have the cash flow to make the periodic payments?

Determining whether your business has the cash flow it will need to make the periodic payment is just as important as determining the total cost of the loan. This is why you need to consider the loan terms. Shorter-term loans will likely include a lower overall dollar cost of funds than a longer-term loan, but will usually include a higher periodic payment –which could become problematic for a business with unpredictable cash flow.

For example, if most of your cash flow happens at the end of the month or on a quarterly basis when your customers pay larger invoice amounts, and that cash flow carries you through the following period, a short-term loan that requires daily or weekly direct debits from your business chequing account (a common practice by short-term lenders) might not be a good idea. On the other hand, if your business has a consistent influx of cash every day or every week, a short-term loan could be a good fit.

In that regard, it’s important to understand the nature of your cash flow, as well as whether you have a positive balance when your loan payments are due.

Understanding Business Loans

Loan costs will vary from lender to lender and, depending upon the loan type, repayment terms can range from a few months to several years. All will impact the cost of the funds you borrow. As a rule of thumb, a shorter-term loan of six months will likely have a lower overall dollar cost than a loan of several years, but the periodic payments will be higher. It is therefore important to understand how the length of the loan term impacts overall cost and the size of the periodic payment.

Most of us are familiar with how to think about a mortgage or an auto loan. Determining the right fit for a business loan, however, is a little bit different and may be more complicated.

Consider the scenario where you’re borrowing to purchase inventory. The cost of borrowed money could potentially impact the profitability of the inventory you’re purchasing. For example, if you plan to turn over the inventory in a relatively short period of time, you may be better off paying less interest and a higher periodic payment over a few months rather than several years. More specifically, if the accumulated interest on $10,000 of inventory is $4,800 on a loan with a term of four years and your margin is 50 per cent (or $5,000 in profit), that particular loan might not be a good fit if you can get the same $10,000 for $1,500 in cost on a shorter-term loan. That’s why, in terms of a business loan, it makes sense to consider the total loan dollar cost when comparing one loan to another and assessing whether the loan fits the particular business use or need.

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