Should your business borrow?

Deciding whether to take out a business loan is a critical decision that requires careful consideration. While borrowing can be a strategic move to accelerate growth, it’s essential to assess the risks and potential downsides before taking on debt. In many cases, borrowing can accelerate growth by enabling investments in opportunities such as expanding operations, hiring new staff, acquiring new equipment or launching new products, provided the debt can be managed responsibly and you are confident in generating sufficient revenue to cover repayments.

To help you decide whether borrowing is the right choice, follow this simple decision tree:

  1. Is there a specific, clearly defined business need for the borrowed funds?
    • Yes: Proceed to Question 2.
    • No: Reevaluate the need. Borrowing for unclear or non-essential purposes is generally unwise6.
  1. Can this need be met with existing funds (savings, retained earnings, etc.)?
    • Yes: Consider using existing funds and ensure you maintain a buffer to protect against dips in income.
    • No: Proceed to Question 3.
  1. Does the potential return on investment (ROI) from the borrowed funds outweigh the cost of borrowing (interest rates, fees)?
    • Yes: Proceed to Question 4.
    • No: Assess the investment opportunity or seek alternative funding sources.
  1. Is the business financially stable and capable of handling the additional debt burden?
    • Yes: Proceed to Question 5.
    • No: Consider strengthening the business’s financial position before borrowing7.
  1. Has a thorough financial plan been created to manage the loan repayment and its impact on the business?
    • Yes: Borrowing may be a viable strategy to grow the business.
    • No: Consider the need for borrowing or explore alternative funding options.

Legitimate Reasons to Borrow

Lenders typically consider the following business projects as legitimate reasons for lending. These reasons include descriptions:

Seizing market opportunities: If a significant market opportunity arises that requires immediate investment, borrowing can allow you to capitalise on it before competitors do.

Funding large projects: Major investments like new facilities, research and development, or large-scale marketing campaigns might require substantial upfront capital that can be funded through borrowing.

Covering unexpected financial challenges: Setbacks can occur in any business, whether it’s late customer invoices, the loss of a large client, sharp increases in overheads such as energy bills, or equipment failure that requires repair.

Entering new markets: Finance can be an option to help fund the added expenses to allow your business to enter new markets3. For example, a small restaurant looking to expand into new markets or high street chains, may need funds to increase production or expand distribution and logistics.

Investing in marketing and advertising campaigns: When your business is just starting or you’re looking to expand your reach, for your business to challenge competitors in the marketplace, you may need to invest in marketing campaigns, such as advertising.

Improving cash flow: A short-term loan can help manage temporary cash flow issues, allowing you to meet payroll or pay suppliers while waiting for customer payments. Many businesses experience busier periods and slower periods, meaning your cash flow can vary seasonally, leading to cash flow challenges.

Investing in new technology or equipment: Investing in new technology or equipment could be necessary to take on new contracts and meet demands, allowing you to increase productivity that increases productivity and reduces costs.

Funding research and development: Research can help your business understand the market you’re trading in and develop new ideas to ensure your business stays competitive.

Acquiring another business: Buying a smaller competitor and merging it with your business could help expand your reach, expertise, and skills, as well as provide access to more customers.

Potential Downsides of Borrowing

Here are some of the key points to consider when assessing any new business loan.

  • Interest payments can impact profit margins, especially if interest rates are high.
  • Excessive debt can cause cash flow problems and put pressure on your business during economic downturns.
  • Significant debt from investors may lead to a loss of control, and you may have to make decisions that prioritise your interests over your own.

 

Getting an understanding of the risks involved requires analysis including scenario simulation. What if future events reverse current conditions?