Borrowing money for your business

All businesses borrow. They need cash for operations, and they need cash to invest in assets so they can build the business. Businesses can get the cash by they need by making a profit. However this may not be enough for growth.

Generally speaking, businesses borrow for one of three basic reasons. They need money to:

• Get started
• Grow
• Smooth out cash flow

When you started your business, you may have borrowed from family or friends. You may have used your credit cards. It could be that your business is a professional services business, and you were able to start small with just a few clients, and it really did not take much money to get started. Perhaps you turned your hobby into a business. Now you’ve reached the point that you need some money to get to the next level. Maybe you are an attorney and you are ready to hire a paralegal. Maybe you need a new lathe for your woodworking shop, or a new delivery van for the catering business. What do you do?

Good news! Even though you have heard all of the bad news about tight credit, there are plenty of things you can do to make it easier to borrow money. There are only two things you have to know.

1. Know yourself and your business.
2. Know your banker.

Know yourself and your business
You need to know about yourself and your business for two reasons. You need to be able to make good plans, and you need to be able to present those plans to whoever is going to lend you money. Give your CPA and bookkeeper a call and get a copy of your most recent financial statements. While you are at it, get copies of the previous few years. Look at everything and not just the P&L. If you don’t understand financial ratios, ask your CPA to explain them. The ratios are tools that you can use (and your lender will use) to evaluate the relationship between your debt and your assets, how much debt service you can handle, how you manage your cash flow, and whether your business is profitable. If you are a sole proprietor or a partnership, you will also want to review your personal financial situation. If you are not sure how to prepare your own personal financial statements, ask your CPA or bookkeeper for help. You should expect to pay a fee for these professional services, but trying to save a little in the beginning could cost you later.

 Once you understand your current situation, you can start working on the future. If you put together a business plan when you started your business, then this part should be easy. All you have to do is update your plan. If you don’t already have a business plan, then develop one. You can do this yourself. There are guides and templates available in many places. You can purchase planning software. You can also ask your CPA for assistance. The Small Business Administration provides a template. Another place to look for help is the Service Corps of Retired Executives (SCORE). This is a link to their template gallery.

However you develop your plan, it will contain these basic parts.

• Summary
• Overview of the business
• Analysis of the market
• Description of products
• Organization and management
• Marketing and sales plan
• Financial details

With a good understanding of your business and a business plan, you will be prepared to get to know your banker.

Know your banker
What does it mean to know your banker? In this case it means a few things. Some of them may not be possible right away because they take time. Some of them you can do immediately.

• Develop a relationship with the bank and with the people in it.
• Get to know everything your bank can do for you.
• Understand what your banker needs from you.

Develop a relationship with the bank and with the people in it
This should be obvious. Remember the movie, It’s a Wonderful Life. Think about the contrast between George Bailey at the Bailey Building and Loan Association and Mr. Potter. Find a bank that wants to get to know you and your business. Figure out who the George Bailey’s in your community might be, and avoid the Mr. Potters.

The other part of this is, once you find your version of George Bailey, you need to be a loyal customer. The bank will not want a relationship with you unless you demonstrate that you want a relationship with it. You should do most of your business with your new bank. You should also try to do it in person. When you walk in the door, you want the people in the bank to recognize you. Loyal customers are as important to your bank as they are to your business.

Get to know everything your bank can do for you
Many business people simply cannot imagine the range of services available at even the smallest community bank or credit union. Most people know about checking and savings accounts. They know about money market accounts and CDs. People know about loans such as mortgages, auto loans, and personal loans. However, did you know that many banks also provide merchant services? Did you know that your bank could help you install an ATM in your store for customers? Did you know that your bank can probably set up a lockbox arrangement so that customer payments can go directly to the bank and your account? Did you know that your bank can probably help with cash management tools such as zero balance accounts? If you need access to cash, did you know you could set up a line of credit instead of borrowing with a term loan? If you take the time to get to know all of the products and services your bank offers you might discover some new ways of managing your cash.

Understand what your banker needs from you
The simplest description of banking is that banks take the money deposited by some customers and lend it to other customers. They pay interest on deposits, and they charge interest on loans. They make money when the interest they charge is greater than the interest they pay. They lose money when customers do not pay back their loans. This means that your banker needs you to deposit money. Your banker also needs you to borrow money and pay it back. If you want to borrow money, you have to make the case that you will do just that.

That is why your first steps were getting your financial statements together and developing your business plan. You will need your financial statements and business plan to make your case. You will typically need the current year and the previous two or three years. Ideally your financial statements will demonstrate that you are solvent and have appropriate liquidity. They may also show how you handle payables and receivables. In short, the statements will explain your current situation and your history. If the statements reveal any serious flaws in your operations, be prepared to explain them.

Your business plan will tell the story that you hope will unfold. You will describe your company and your customers. Your plan will describe your products and why customers will buy them. It will explain your marketing and sales plans. Finally, your plan will make clear how you will use the money you borrow. This is the most important part because it will also explain exactly how you expect to pay the money back.

Ways to borrow money

Many businesses operate with borrowed money. In financial terms, borrowed money gives a business operating leverage. The term leverage means the same thing that it does in physics. A business that borrows uses the money like a lever to amplify the force that it can apply. Businesses also borrow money because it can be less expensive to borrow than to raise money other ways. Creditors typically have some sort of claim on a business, and they can be fairly certain of a return, so they demand less risk premium than equity investors. Even so, borrowing money can cause problems for businesses. It is important to understand how to borrow.

Sources of funds
Generally speaking, businesses commonly borrow four ways.

1. Borrowing a lump sum: This is what people generally think of when they think of borrowing money. A borrower obtains money from a lender for a period of time. The borrower pays the money back according to some sort of schedule and pays the lender interest on the outstanding balance. This is typically the least expensive way to borrow.
2. Securing a line of credit: With a line of credit, the borrower arranges for a lender to loan money as needed. The borrower does not obtain the money until it is needed. Interest is only paid on the outstanding balance. The lender may charge a fee for maintaining the line of credit. This costs more than borrowing a lump sum, but since interest is only paid on the outstanding balance, it could cost less than borrowing a lump sum. For some businesses this could be as simple as using a credit card. For other businesses, this could involve a sophisticated arrangement with a lender.
3. Trade credit: Many business owners do not think of trade credit as financing, but it is. Vendors do not always demand cash payment on delivery of goods. They often offer terms allowing some period of time to pay. Vendors offering time to pay may also offer discounts for early payment. The cost of trade credit varies.
4. Securing customer payment in advance: This is more common in construction or in businesses that use progress billing than in other industries. A good example might be a contractor that secures an upfront payment for supplies before beginning a remodeling project.

There are advantages and disadvantages to each of these methods, and business owners should consider the cost of each method, how they affect cash flow, and flexibility. If your business needs a large amount of money for a set period of time to purchase equipment or inventory, then it probably makes sense to borrow a lump sum.

If you need cash to smooth out cash flows or to address timing issues, then you might consider a line of credit. Businesses that buy and sell expensive inventory might consider a line of credit. For example, an antique dealer might keep a line of credit open to have funds in case he or she makes an extraordinary find.

The advantage of borrowing the lump sum is that it costs less for the amount borrowed. However, if the business cannot generate an immediate return because the funds are sitting waiting to be used, then even a lower cost is too high a cost and the payments on the loan are going to be due regardless of whether the funds help produce additional income. A line of credit, on the other hand, may require a small fee, and the cost of funds will be higher. However, since the interest is only paid on outstanding balances, then the total cost is likely to be smaller. The table below put this into perspective. With the $50,000 loan, interest is due every month, and the total amount paid is actually higher than with the line of credit even though the line of credit has a fee and a higher interest rate. This is because even though the highest amount borrowed was greater, the average amount was lower, and the time the balance was outstanding was shorter.

	Lump Sum (6%)		Line of Credit (10%)*
	Borrowed	Interest	Borrowed	Interest
January	$50,000	$250		$21
February	50,000	250	$75,000	646
March	50,000	250	50,000	438
April	50,000	250		21
May	50,000	250	10,000	104
June	50,000	250	10,000	21
Ttl Cost		$1,500		$1,251
*$100,000 Line of credit at 10% with a .25% fee.

The decision to use trade credit is dependent on a variety of factors including the terms, business cash flow, and the cost of other sources of funds. It is possible that if the business has sufficient cash flow, trade discounts that may be offered by a vendor may make trade credit less attractive.