One of the greatest misconceptions about SME financing is the notion that taking on debt is always a bad thing.
Many people associate loans (aka. debt financing) with financial difficulties and cash flow problems and often assume that companies will only take up loans if they are in a poor cash position. However, this cannot be further from the truth.
Did you know that even large and established companies such as Apple still take on business loans? There are many advantages to debt financing that are often overlooked by SME-owners due to risk adversity or years of hearing misguided information.
This is the opportunity for you to uncover the perks of undertaking business loans (and the precautions you can take) so that you can clear your misconceptions and make an informed financing decision.
1. To Speed Up Business’ Expansion and Growth Rate
Common Myth: A healthy business always has excess cash on hand and will not require any form of business loans.
The truth is that excess cash may not always be a good thing, as it begets the question of “Why isn’t this excess funding being reinvested into new investment ideas and expansion opportunities?”
A healthy business will usually be seeking ways to speed up their rate of growth. Hence, it will often utilise excess cash to increase its capacity for growth (through upgrading equipment and machineries, increasing marketing efforts or expanding working capital). However, relying on cash-flows alone to finance growth is often insufficient for businesses and may cause them to take a longer time to reach its goals. Therefore, many successful SMEs choose to leverage on business loans to accelerate its expansion and growth, which is an opportunity you can consider for your business as well!
Possible Precautionary Actions: Create a revenue forecast based off existing balance sheets to ensure that your business will be profit-making on top of covering loan repayments.
2. To Avoid Cash-Flow Issues
Common Myth: Cash-flow problems are an inevitable reality for SMEs.
It is true that many SMEs struggle to maintain a positive cash-flow due to a multitude of reasons:
- Freak Incidents i.e. Warehouse fire or natural disasters that may affect supply shipments.
- Cyclical Business Downturns i.e. A restaurant chain may face business slowdowns in certain periods of a year, where their operating costs may be greater than that period’s revenue.
- Poor business decisions/estimations or negligence of partners i.e. A firm overestimates its financial ability to follow through with a large project or subcontractors face financial problems due to the main contractor’s delayed payments.
These unexpected circumstances may cause an inevitable fall in period cash flows. But they can be easily remedied through undertaking business loans in advance, to allow cash to be set aside as a buffer against such circumstances. A stable and affordable line of credit also allows your business to continue operating as normal during cash-strapped periods. Generally, loans help prevent your overall business cash flows from being susceptible to uncontrollable situations and cyclical downturns.
Possible Precautionary Actions: There are other actions you can take to better manage your cash flows, you can find out more on 5 Steps For Better Cash Flow Management.
3. To Capitalise on Business Opportunities
Sometimes, there may arise unexpected opportunities for the business such as:
- Discounted bulk orders of inventory
- Retail space priced lower than market rate
- Good deals on vehicles auctioned off by banks in a foreclosure
Having extra cash on hand or obtaining a business loan will allow your business to capitalise on these opportunities in time to potentially generate greater revenues. This is also important for businesses in capital-intensive industries such as manufacturing. They often need to spend large amounts on machinery, labour and inventory far before they start receiving any revenue from their projects. They risk having insufficient funds to complete the project if unexpected expenses are incurred midway through. A solution is to cover these heavy initial investments with short-term loans to leave the business with sufficient cash reserves.
Potential Precautionary Actions: Conduct a revenue forecast to estimate the true costs and profits generated from this investment. It will be helpful to determine the return on investment of the opportunity through weighing the cost of the loan against the potential revenue that can be generated. Basing decisions on hard number rather than gut instincts will prevent over-enthusiasm from clouding your judgment.
4. To Build Creditworthiness and Profit Off It
Do you know that taking on a loan can reap long-term benefits for your business?
When your business undertakes a loan, it establishes relationships in the financial sector and builds up lenders’ confidence through timely repayments. This is especially important for young SMEs that often find it difficult to qualify for larger loans when they lack a strong credit history to support its request.
Responsible debt financing will help to boost your business’ creditworthiness and business credit score. This may increase your chances of getting bigger loans in the future as your business grows.
The saying that the “bank is a place that will lend you money if you can prove that you don’t need it” also holds very true here. The best time to apply for a loan is the period where your business is financially strong, maintaining healthy cash flows and has a comprehensive business plan for future growth. It is wise to take advantage of periods with higher credit ratings to apply for loans, as banks and investors will perceive lower risk and issue a lower interest rate on the debt. SMEs can also re-invest excess cash in securities or instruments that repay a higher interest rate, profiting off the difference in interest rates.
Possible Precautionary Actions: SMEs should be cautious of taking on an early loan and ensure its ability to afford the loan as every late payment on a small loan may affect their qualification for future bigger funding.
5. Debt is Cheaper than Equity Financing
Common myth: Equity Financing is better for SMEs as investors will bear all risks and SME-owners will not be liable if the business fails.
Although equity financing has many upsides such as decreasing risk for SME-owners and allowing the business to have more cash and less debt, the truth is that its downsides are incredibly large.
Equity is an expensive financing method as it incurs a greater loss in the long-term. It requires you to give up a stake of your business in exchange for cash. Although 5%, 10% or even 15% may seem a reasonable percentage of equity to give up when your business is cash-strapped, it actually dilutes your ownership of your business. Ownership governs your control over management decisions affecting small decisions such as the hiring of workers as well as big decisions such as which projects to undertake. The general rule of thumb is that equity investors will seek to have a degree of authority over decisions made by the businesses they invest in, making it unwise to relinquish a large portion of your ownership over your company.
On the flip side, debt financing allows your current management to retain full control and does not dilute your ownership. It also has other advantages such as:
- Tax benefits: Interest payments on loans are tax deductible and will decrease the amount of revenue that’s taxable. Comparatively, dividend payments to equity-holders are not tax deductible.
- Lower obligations: As equity-holders risk losing all their investments if the business closes down, investors usually expect higher returns. Comparatively, business loans can usually be sourced at a lower interest rate.
- Easier forecasting: Loan payments do not fluctuate as much as equity prices, making it easier to forecast expenses.
Possible Precautionary Actions: Too much of a good thing can be a bad thing. Although debt-financing is a good option for SMEs, it is important to not over-leverage and risk defaulting on loans. There is a significant amount of risk for the borrower if they lack confidence in loan repayments. Larger SMEs often use a combination of debt and equity financing to reduce the downsides of each method. You can find out more here on Debt vs Equity Crowdfunding.
In the past, SMEs often found it difficult to obtain a loan even if they recognised its advantages and are interested to undertake one. This usually occurs due to the long application period from traditional financial institutions and lack of business collateral or credit history to back its loan request. This is a common problem faced by SouthEast Asian SMEs that you can find out more about here on The SME Funding Gap in SouthEast Asia.
Fortunately, the proliferation of online financing platforms has led to more sources for SMEs to obtain loans from. One key option is Peer-to-Peer (P2P) loans that can be obtained through debt crowdfunding platforms such as Funding Societies in Singapore. This enables SME-owners to obtain loans much quicker — with simpler request procedures which can even be done through this popular business loan mobile app FS Bolt. You can find out more about Peer-to-Peer Loans here to make a more informed financing decision in the future!
This article was first published on Funding Societies.
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By Funding Societies
Funding Societies is the leading P2P lending platform for SMEs in Singapore and Southeast Asia. Established in 2015, they have funded up to S$579.54 million to SMEs to date. They are also licensed by the Monetary Authority of Singapore.