Understanding the Basics of Small Business Financing
Taking on debt can be a polarizing issue. Most business owners have a strong opinion about using outside small business financing like loans and credit to grow a company. Though debt financing might not be ideal for every business, there are many scenarios where it can be a smart move that jumpstarts a company to help it reach its goals. Determining whether or not debt is right for your business requires some financial analysis, research into small business financing options, and preparation for the application process.
Develop a Cash Flow Analysis Before Seeking Small Business Financing
Cash flow describes the passage of money in and out of your business. Cash flow analysis measures these things to help your company better manage its finances. While profit and loss (P&L) and income statements can also be used to project cash flow trends in your business, this particular type of analysis is unique and essential, because it accounts for non-cash items and expenses in its calculations. This gives you a very accurate figure for available net cash, which is essential when determining what your business can afford. This type of analysis effectively measures the company’s liquidity – e.g., whether or not it has enough cash coming in to pay its bills each month – rather than profitability.
A cash flow analysis consists of three parts:
- Operations Activities: This is the cash that a company produces internally. It includes inflow, such as sales and paid receivables, as well as outflow, such as payroll, taxes, payments to suppliers, and the depreciation of business assets like computer and office equipment (e.g., operating expenditures). In this category, outflow is specifically the items/services needed to create what you sell.
- Investing Activities: This is money related to the purchase or sale of assets unrelated to day-to-day operations. This comprises real estate, investment securities like CDs and bonds, and manufacturing equipment. Inflow is the money made from selling these assets, outflow is the money spent to purchase these assets. Capital expenditures fall into this category, including the acquisition and maintenance of fixed physical assets like land, buildings, and equipment.
- Financing Activities: Money in this category encompasses debt and equity transactions such as distributing dividends, issuing stock, and making payments on business loans. In the case of loans, receiving the loan is recorded as inflow while making payments on the loan is recorded as outflow.
Once you’ve documented inflow and outflow in each of these areas for a chosen period (usually a month), calculate the difference and then add those three figures up for a closing balance. Comparing that figure against the period’s opening balance will let you know whether or not you have positive cash flow.
Preparing a cash flow analysis will help you immensely in securing a business loan. It shows that you’ve done your homework and know what your company can comfortably afford. A lender wants to see that you will be able to make your payments each month, so observing a bit of a cash flow cushion will make a financier more likely to take a risk on your business.
Additionally, identifying cash flow trends – perhaps things become tight in the summer because of low seasonal demand for your product – can help you prepare for slow times and even secure business financing to help bridge cash flow gaps. There are certain types of short term loans specifically for this type of business seasonality.
Estimate How Much Financing Your Small Business Will Need
Creating a cash flow analysis will allow you to make better-informed decisions about your business’ financial future. If you know you’ll need to make big purchases in the future to grow your business, reviewing your analysis report will enable you to see when you’ll be able to afford that expenditure. It can also help you determine when small business financing is necessary.
Additionally, these numbers will shed light on how big of a loan payment you can comfortably afford each month. Knowing this will clue you in to what type of loan terms will work best for your company.
However, the numbers on a cash flow analysis are not the only figures you need to know when pursuing a small business loan. It’s important to have an exact amount in mind when you approach lenders about business funding. First, it demonstrates that you’ve done your research and know exactly how much your investments will cost. Providing a ballpark figure can make it seem like you haven’t thoroughly thought through your business plan, and lenders prefer to work with companies that have planned and strategized in great detail. Furthermore, understanding the exact amount of money you’ll need will help you better plan and select the small business financing option that will work best for your needs. Going in to the loan application process fully informed will let you choose the offer with the best rates and terms.
Research Small Business Financing Options
Once you know how much you need and what you can comfortably afford on a monthly basis, it’s time to select the loan that’s best for your business. Some small business financing options include:
- Long term business loans: These loans feature terms that can last from one year up to 20 years or more depending on the loan’s application. A business pays a long term loan back with a set monthly payment plus interest. Interest rates vary based on a number of elements such as the financial climate, the length of the loan, your business’ financial history, and the lender’s preferences. Long term business loans are usually used to fund investments that will last the lifetime of the loan. For example, a piece of machinery expected to last 10+ years. Generally, longer term loans are only available to established businesses with a proven financial history.
- Short term business loans: Short term loans are similar to long term business loans, but with terms lasting from about 3 months to a year. Interest rates are usually higher than long term loans. Traditional bank lenders offer short term business loans, as well as other organizations like alternative online lenders. These small business loans can be used to fund short-term needs, like seasonal inventory or cash flow gaps.
- SBA loans: In order to promote small businesses in the United States and positively impact the economy, the U.S. Small Business Administration (SBA) offers a program that guarantees the loans of small businesses. What this means is that, should the business default, the SBA will pay back a portion of the outstanding loan amount to the lender. This encourages lenders to work with small businesses, which they might otherwise avoid because of the risk associated with fledgling companies.
- Business line of credit: A business line of credit functions a bit like a credit card. A bank will offer a business a predetermined amount of money that it can borrow as needed. Unlike a loan, the business doesn’t get that money upfront in one lump sum. The business can pull money out as needs arise and pay it back on a monthly basis, plus interest. Interest is only calculated on the amount used, which is an advantage to the company. Many businesses like to have a line of credit established in case of emergency or unexpected opportunities.
- Working capital loans: Working capital loans are short term business loans used to finance the day-to-day operations of a company. Many companies use these loans to keep things running during slow seasons. They can also be used to gear up for busy times or large purchase orders. They are more accessible than many other types of loans, though, they tend to have higher interest rates.
- Equipment financing: Equipment is one of the most expensive investments many businesses have to make. Equipment loans are easily accessible to small businesses, even businesses with bad credit, because the equipment itself is used as collateral. Businesses pay off the cost of the equipment a bit each month, plus interest. If the business defaults, the bank reclaims the equipment and sells it to make up the difference.
- Accounts receivable financing: Also known as invoice factoring, accounts receivable financing involves a business selling the invoices it’s issued to a factoring company. The business receives money for the invoices upfront (minus fees), and the factoring company collects on the invoices. For businesses with an aversion to debt, this can be a good small business financing option, because it involves money that’s already been made, which is less risky for all parties involved.
When exploring which small business financing option is the best fit for your company, be sure to also compare lenders. Different lenders offer varying rates and terms. Some specialize in different areas. Some online lenders allow you to input your needs and receive multiple quotes within hours, a convenient and efficient way to comparison shop.
Prepare for the Application to Get Your Small Business Financing
Before you begin the loan application process, take the time to prepare your company to land the best package available. Start out by:
- Conducting a cash flow analysis to determine how much money you need and what you can pay comfortably on a monthly basis
- Deciding what type of loan you’re targeting
- Researching different lenders and choosing those that you would like to work with
- Checking your credit report to ensure you’re in good standing
Lenders will request lots of documentation. Have all of these things at the ready when you begin applying for small business financing:
- A thorough business plan that lays out your financial plans for the next three to five years
- Recent tax returns
- An updated balance sheet
- A cash flow analysis
- A recent income statement
- Up-to-date balance statements
- A list of current outstanding accounts receivable and accounts payable
- A value appraisal of any collateral you wish to use
- Business licenses and registrations
- Legal proof of ownership
- Any contracts you have with other parties (such as franchise documentation or commercial leases)
- Insurance policies
Along the way, lenders might ask follow-up questions on your application. Be prepared to answer the following:
- Why do you need this loan?
- How will you apply this money to help grow the business?
- What is your background? Do the members of your management team have successful track records?
- Do you have any other business debt? Who are your creditors? Do you have investors?
- Do you have collateral you can use to back the loan?
With thorough preparation and a specific goal in sight, your company will be on its way to securing the small business financing it needs to reach the next step on its growth path.