Small businesses require funds for various reasons. A loan might be required for business expansion, purchasing inventory, purchasing equipment, increasing working capital or for property purchase. There are various means to secure a small business fund like crowdfunding, traditional bank loan, angel investors, and venture capitalists. Small business loans are one of the most common loans sought after.
However, for a small business, securing a small business loan is often difficult. Small business bank loans have their fair share of advantages and disadvantages. Every small business owner should weigh the risks associated with a small business loan and see if it’s the right fit.
Here are few reasons that explain why you should think twice before taking a small business loan.
Difficult to Secure
- Small business loans can be difficult to secure because the borrower often has to qualify a large number of prerequisites and go through a heavy documentation process. One of the most important requirements for the borrower is to have good credit.
- The success of your business loan application often depends on your credit score. It is the minimum threshold required to qualify for a small business loan. Lenders analyze your credit history to help determine your ability to pay back debts.
- Many of the small business owners may have a bad credit history or no credit rating. According to the NSBA Small Business Access to Capital Study, 20% of small business loans are denied due to business credit. And research by Cardhub stated that on an average, a business needs at least 12-18 months to improve its business credit.
- Small business owners can take the assistance of non-profit organizations or microloans, where creditworthiness is not evaluated for loan approval.
Maintaining Debt-to-Equity Ratio
- To qualify for a small business loan, it is often necessary that you have equity (current assets) above a certain percentage of your debt (current liabilities). And in order to take advantage of the loan, you must be able to balance the two equally.
- If lenders find that you have failed to maintain this “debt-to-equity ratio”, then you might be requested to repay immediately. It’s a high-risk situation that could end in bankruptcy.
- One of the primary risk factors associated with small business loans is a high-interest rate. High-interest rates increase the cost of borrowing and companies will have less disposable income, which can affect functioning of a business and can slow down its growth rate.
Risk of Pledging Collateral Against Loans
- Most of the commercial business loans are offered on a security basis. Small business owners with low credit scores may not be granted a loan unless they pledge collateral. If you default the loan, the lender has the right to take possession of your asset.
- Small business owners short on collateral could to give up on securing a business loan. But if they are forfeiting their assets, it is important they know the value of their possessions against the amount they are taking as a loan.
No Cash for other Business Endeavors
- Borrowing a small business loan could help you kick-start your business. But unfortunately, small business loans have to be repaid every month with interest and that is an expense for small business owners. As we know, running a business is exhaustive and expensive, and when a large portion of your profits are allocated for loan repayments, it could result in problems with cash flow.
- With insufficient funds and regular monthly loan payments, small business owners may be forced to give up on crucial business growth opportunities. It might be an investment in new equipment, inventory, or ventures that are defining the current market. And taking additional finances to support these areas will do no good; instead there will be more problems adding to the mounting debt.