Factors to Consider Before Taking Business Loans

 Omolabake Fasogbon

While money is the soul of business, loans remain one of the available vehicles to propel business ventures.

Obtaining loans however may not be the best decision in all cases, given the inherent risks and obligation for responsible borrowing.

A number of reasons, including internal and external such as cash flows, financial management, market and economy, operational challenges, and other loan-related issues add up to contribute to why businesses fall into debt, which in extreme cases go bankrupt or fizzle out.

Reports point out to a growing trend of local businesses filing for insolvency due to mounting debt burdens, while many are struggling to meet loan repayments amidst economic challenges, including inflation and currency fluctuations. This comes with dire consequences not only for lenders, the economy and the borrowers also feel the pinch. 

It is thus important that before deciding to take a loan, borrowers should reassess their worthiness, understand the risks associated with debt, and make informed financial decisions. 

Here are some key considerations to note before borrowing, as drawn from different resources:

Is loan your best option?

Before seeking a loan, carefully assess whether your financial difficulties stem from a genuine need for capital or simply a cash flow problem. If the latter, explore strategies to improve cash flow, such as incentivising early payments from customers. Furthermore, evaluate if a loan aligns with your business objectives. A comprehensive business plan, which is often a lender’s requirement, is crucial for determining the necessity and appropriate size of a loan, and for clarifying how it will contribute to business goals.

Research Available Loan Options 

Before applying, thoroughly investigate the different types of loans offered by banks and other financial institutions, paying close attention to interest rates and repayment terms. This research will empower small businesses to choose the loan product that best suits their specific requirements.

Check Credit Score and Gather Paper Work

Business financial statements, like a current profit and loss statement from the last three fiscal years, a cash flow statement, and your balance sheet. Additionally, personal and business income tax returns for the last three years, ownership and affiliations, including any other business you have a financial interest in and any partners in your business.

 Prepare a Robust Business Plan

Lenders typically require a solid business plan before approving a loan, so small businesses should prepare a comprehensive plan outlining their current operations, future growth plans, and loan utilisation to demonstrate their repayment ability and increase approval chances.

Choose Right Lender

Businesses should carefully select a lender that meets their specific needs by researching and comparing loan products, interest rates, repayment terms, reputation, customer service, and lenders’ experience in supporting small businesses.

Understand Total Cost

A comprehensive understanding of loan costs is essential. Beyond the principal, borrowers must consider all associated expenses, such as interest, potential penalties, management fees, and any other hidden charges, as these can substantially impact the overall cost of borrowing. 

Understand Interest Type

This can significantly impact a total loan cost. Simple interest is calculated only on the original loan amount, whereas compound interest is calculated on both the original amount and accumulated interest, potentially leading to a substantial increase in long-term loan costs.

Measure Default Consequences

Before committing to a loan, understand the consequences of defaulting on payments, including penalty fees and other potential issues that can arise from missing principal or interest payments to avoid unexpected complications.

Understand Collateral Release Terms

Review the process for reclaiming your pledged asset once the loan is fully repaid, ensuring you understand the terms before finalising the loan agreement.

Finally, before signing a loan agreement, prospective borrowers should consult a financial advisor, lawyer, or accountant to review the contract and determine the optimal borrowing amount and timeline.