How to Use Loans and Credit Wisely

As a small business owner, managing debt can be one of the most challenging yet crucial aspects of financial success. While taking on debt may feel uncomfortable, it is often necessary for businesses to grow, invest in new opportunities, or weather unforeseen circumstances. The key to successful debt management lies in understanding how to use loans and credit wisely to maximize benefits and minimize risks.

In this final installment of our Small Business Financial Management Series, we’ll explore how to manage debt effectively, use credit responsibly, and leverage loans to help your business thrive.

Understanding Business Debt and Its Role

Debt isn’t inherently bad; it’s how you manage it that makes the difference between it being a tool for growth or a burden. When used responsibly, debt can help fuel expansion, cover cash flow gaps, and improve operational efficiencies. On the other hand, unmanaged debt can lead to high-interest payments, strained relationships with creditors, and financial instability.

There are two main types of business debt:

1. Short-Term Debt: This type of debt is typically used to cover day-to-day expenses or manage cash flow fluctuations. It is usually paid off within a year. Common examples include lines of credit or short-term loans.
   
   
2. Long-Term Debt: Long-term debt is used for bigger investments, like purchasing property, equipment, or expanding operations. These loans often have repayment terms that extend over several years. Common examples include commercial mortgages and equipment financing.
   
   

Step 1: Use Debt Strategically

The first step in managing debt wisely is ensuring that you are taking on debt for the right reasons. Here’s how to approach borrowing strategically:

• Invest in growth: Use loans to finance business expansion, purchase equipment, or hire additional staff that will help generate more revenue in the long term. For example, using a business loan to buy equipment that will improve production efficiency can be a smart investment.
  
  
• Use debt for cash flow management: Business owners often use short-term debt, such as a line of credit, to cover temporary cash flow shortages. If you have a seasonal business, for example, you may need to borrow money to cover costs during off-peak times.
  
  
• Avoid using credit to cover operational inefficiencies: Avoid taking on debt to cover ongoing operational losses or poor financial management. If your business consistently needs debt just to maintain its regular expenses, it’s time to revisit your business model, streamline operations, or rethink pricing strategies.
  
  

Step 2: Borrow What You Can Afford to Repay

When it comes to borrowing, it’s important to borrow only what you can afford to repay. Consider your current and projected revenue and cash flow when deciding how much debt to take on.

To determine how much debt you can handle:

• Evaluate your cash flow: Look at your monthly income and expenses. Can your business comfortably handle monthly repayments while still covering other obligations like payroll, rent, and utilities?
  
  
• Calculate the debt service coverage ratio (DSCR): This ratio measures your business’s ability to repay debt. The DSCR is calculated by dividing your business’s net operating income by your debt obligations. A DSCR of 1 or higher indicates that you can comfortably meet your debt obligations. If the ratio is less than 1, you may struggle to repay debt.
  
  
• Consider interest rates and terms: The interest rate and repayment terms will affect your debt burden. Shop around for the best rates and terms that match your business’s financial situation. Always review the total cost of borrowing before committing to any loan.
  
  

Step 3: Avoid Over-Borrowing

It’s easy to get excited about the possibilities that come with having access to credit. However, over-borrowing is a common pitfall for small business owners. Taking on too much debt can lead to cash flow problems and increase your risk of defaulting.

To avoid over-borrowing:

• Only borrow for what you need: Stick to your budget and avoid borrowing more than necessary. If you take out a loan for $100,000 but only need $80,000, you’ll be paying interest on the extra $20,000 without receiving a return on it.
  
  
• Don’t rely too heavily on credit: Excessive reliance on credit for day-to-day operations can create a cycle of debt that’s difficult to break. It’s important to balance borrowing with strong cash reserves and other revenue-generating activities.
  
  

Step 4: Understand Your Loan Terms and Conditions

Before signing any loan agreement, ensure you fully understand the terms and conditions. Here are some critical elements to look out for:

• Interest rate: Make sure you know whether the interest rate is fixed or variable. A fixed-rate loan means your monthly payments will remain consistent, while a variable-rate loan may fluctuate over time.
  
  
• Repayment schedule: Understand how often your repayments are due and whether the loan is structured to pay down principal or interest first. This will affect how quickly you reduce your debt.
  
  
• Collateral: Some loans require collateral, such as property or equipment. Understand the risks associated with pledging collateral in case you can’t repay the loan.
  
  
• Fees and penalties: Pay attention to any fees, early repayment penalties, or other charges that may arise during the loan term. These can add up quickly and affect your overall financial situation.
  
  

Step 5: Make Timely Payments

Once you’ve taken on debt, it’s essential to make timely payments. Late payments can negatively impact your credit score, which may affect your ability to secure future financing. To ensure timely payments:

• Set up automated payments: Automate your loan payments so that you never miss a due date. This ensures you stay on track and avoid penalties.
  
  
• Monitor your cash flow: Regularly track your business’s cash flow to ensure you have the funds available to make payments. If your business experiences a slow month, consider using a line of credit or savings to cover the payment.
  
  
• Stay organized: Keep a calendar or digital reminders for upcoming loan payments. Being proactive will prevent payment delays and show your lenders that you’re responsible.
  
  

Step 6: Keep Your Debt in Check with Regular Reviews

Managing debt is an ongoing process. Regularly review your debt and financial situation to ensure you’re staying on track. As your business grows, you may need to refinance or adjust your debt structure to optimize your finances. Always keep an eye on:

• Debt-to-income ratio: Monitor your business’s debt-to-income ratio to make sure it stays manageable.
  
  
• Refinancing options: If interest rates drop or your financial situation improves, consider refinancing your loans to get better terms or lower rates.
  
  
• Business performance: If your business experiences significant growth, you may be able to pay down debt more quickly or take on additional financing for expansion.
  
  

Smart Debt Management Equals Business Success

Using debt wisely can be a powerful tool for growing your business. By borrowing strategically, managing payments, and keeping debt levels in check, you can leverage loans and credit to fuel your growth while maintaining financial stability. At American Bank, we understand the importance of sound financial management, and we’re here to help small business owners navigate the complex world of debt.