There are both advantages and disadvantages in incurring borrowings so seek advice from your financial adviser before signing that bank loan agreement
Contrary to the common belief that banks only lend money to those who don’t need it, banks in practice do lend to businesses or entrepreneurs who need money. However, banks generally do so not to get you out of trouble or to get you started in a business. But if you have been in business for over two years and have been operating quite profitably, you would have a good chance of getting loan from the bank when you need it.
Bank loans are helpful when used prudently, but it can be destructive when abused. One advantage of borrowing money is, of course, that it gives you leverage. This means that you can use other people’s money to expand your business, and the incremental income that you can realize from such expansion can increase your return on investment.
Assume, for example, that you decided to invest in a franchise business that’s worth P500,000 and is earning P50,000 annually. If you used your hard-earned savings as capital for that business, you would be earning only 10 percent annually. However, if you borrowed money to partially finance the business—say, 70 percent of it—and then you finance the balance for P150,000, you would be earning 33 percent. That’s a good 23 percentage points better than when you use your personal savings as capital!
When you borrow money, the bank or lender normally won’t have any say on how you manage your business. There is therefore no need to consult your bank or lender or to get its approval when you plan to expand or buy a new business. Moreover, unlike when you have a passive investor or financial partner, banks won’t get any share of your profits. All you need to do is to make a fixed amount of repayment for the loan—an expense item that that you have already computed against your projected cash flow.
The other benefit in borrowing is that you need to pay interest to the bank. But, some of you may ask, why should paying interest to the bank be considered a benefit? The reason is that you can actually claim the interest as expense against your income. This interest expense will enable you to lower your tax payments, thus reducing your cash expenditures. This is better than paying dividends for the same amount to your investor because such dividends aren’t tax-deductible at all.
Of course, while there are advantages in borrowing, there are also disadvantages. One downside is the effect of fixed loan repayments on your cash flow. When your business slows down due to seasonality—say, for instance, when your sales suddenly falls steeply in January after the Christmas holidays—you are forced to make your loan repayments even if you need the funds badly for your quarterly inventory build-up. The situation will be worse when you are in a losing business and you have to constantly struggle with your cash flow to meet your fixed loan repayments.
Normally, when you apply for a loan, the bank may require you to put up collateral in the form of real estate, equipment, inventory stocks, or any assets that the bank can foreclose in the event that you default on your loan. Thus, when your business venture fails to take off and you can’t pay your loan on time, you risk losing your valuable assets. A horrible scenario is when your business debt forces you to part with the family house, your child’s educational plan, or your prized family heirlooms or personal jewelry.
Making a loan
Deciding on whether to borrow or not to borrow can be tricky. You may need to consult with your accountant or financial adviser on the possible effects of incurring loans on your business. In any case, a carefully done feasibility study may be needed before you decide to use borrowed money to finance any business expansion. On the other hand, if you are planning to venture into a new business, it may be wise to consider getting investors instead of relying on bank loans. This way, you will pay your investor only if the business turns a profit. This reduces your risk if the business fails.
For your regular working capital requirements, however, it may be a good idea to get financing support from the bank from time to time. Such loans will allow you to budget your payment schedules realistically.
Financing support from time to time may be good for your working capital needs.
Henry Ong, CMC, CMA, is president and COO of Business Sense, a business advisory firm that provides expert solutions to small and medium sized companies. You may reach him at email@example.com.
This article was originally published in the April 2007 issue of Entrepreneur Philippines.