The Importance of Planning Your Financing Needs
Carrying Out Your Business Plan
One of the aspects that will contribute most to the success of your small business is the right financing. Having a clear idea of your financing needs and the potential sources of financing will form a fundamental part of your planning phase and should be incorporated into your business plan. Financing plays a key role in the overall management of your business – when you have sufficient and timely financing, you will be able to carry out your business plan the way you intended.
Keeping Your Business Running
Financing, as any other aspect of your business, requires planning, consultation, and research. There are many different sources and methods of financing available and you will need to determine what type, or what combination of types of financing would be best for your business. By choosing correctly, you will ensure you have sufficient working capital to sustain your operation through periods of fluctuating cash flow.
Taking Advantage of Opportunities
Having your financing in order will also allow you to make the necessary investments in property, plant and equipment when you need them, and to take advantage of opportunities for growth and expansion, by being able to purchase more merchandise, materials, and supplies to meet a higher volume of customers orders, to hire employees and contract outside services when you need them, and to rent or purchase additional space or facilities when you face growing demand for your products and services.
Choosing the right financing also directly affects your bottom line. Interest costs can be significant. When you can plan ahead and arrange for collateralized loans, instead of short-term loans or cash advances to pay for major purchases, you can save a considerable amount in interest. When you have analyzed and projected your repayment capacity, you may find that you can meet the monthly payments for a loan with a shorter term, and save a significant amount as compared to a longer term loan. By evaluating the different forms of financing, their conditions, and interest rate, you can use them efficiently, with the objective of reducing your overall financing cost.
Evaluating Your Financing Needs
Your Personal Situation
The first question you may need to ask is whether you really need additional financing, or whether you can manage with the resources you already have. Do you have your own personal sources of financing, such as credit cards, lines of credit, or a home equity loan? And, what is the cost of those types of financing? Are you willing to use your personal credit for your business, or would you prefer to keep them separate?
What Will the Financing Be Used For?
For what specific purposes will you use the financing? If you are using your own personal credit to finance your business, you want to ensure you are using it wisely. If you have friends or family members who are helping you finance your small business, it will be good for them to know exactly how their money is being used. And a bank or other outside lender will want to know the specific purpose of your loan or credit application. If you need the financing to purchase property or equipment, they will probably require that these assets be placed as collateral for the loan.
Do you need short-term, medium term, or long-term financing? Over time you may use each type of financing, depending on the purpose. The term of a loan or credit will determine the interest rate charged, and the monthly installments. Different timing requirements mean different types of financing. Financing for major purchases, such as real property, or large machinery, would generally be over a longer term and would probably involve a collateralized bank loan. Financing for temporary working capital shortages would be for a shorter term, and you may be able to use a credit card, line of credit, or short-term bank signature loan.
In general, you will find the best financing conditions when you can anticipate your needs and have time to compare different alternatives, rather than having to borrow money quickly when you are under pressure to meet your current obligations.
Economic and Market Conditions
How are the economic conditions in the market or industry in which your business operates? In general, financing will be more readily accessible when the market or industry is in a prosperous period, with sustained growth. And on the contrary, it may be more difficult to obtain financing when times are hard, or your industry, market, or geographical area is in decline. Nevertheless, monetary measures to reduce interest rates and stimulate the economy could work to your advantage during these hard times.
What are the risks associated with the financing? You should evaluate risk from both sides. If you do not get the financing you need, your business may not grow and prosper as you would like, or it may even be in jeopardy as a going concern if you cannot meet your obligations. On the other hand, if you obtain financing you run the risk of default if things do not go as well as you expected and you cannot meet your payments. Your creditors will want to reduce their risk in lending you money, and if you can evaluate and weigh your risks, you will be in a better position to make good decisions about your financing and convince your creditors that you are a good credit risk. Risks should not be either over or underestimated – they should be evaluated clearly and objectively.
How strong are you or your company’s administration in managing credit and finances? Good management is a key factor that lenders will take into consideration in their decision whether to grant credit to your business. If you do not have the expertise or time to manage your business finances, you may need to hire a financial manager, take on a financially-oriented partner, or seek the assistance of a financial advisor or consultant.
How do your projected financing needs align with your business plan and strategy? Does the need for financing form part of the original plan, or is it due to some unforeseen circumstance? When the need for financing is incorporated into your business plan, with clear projections of future cash flows showing how you plan to repay loans and credits, your potential lenders will probably feel more confident in your repayment ability because you have already taken it into account. You will also have a reference point and guideline to help you in managing your finances.
Evaluating Your Likelihood of Obtaining Financing
By being aware of some of the criteria lenders may take into consideration in deciding whether to grant credit to a small business, you can prepare yourself, and make any necessary modifications or changes to enhance your chances of obtaining the financing you need.
Personal Credit Score
What is your personal credit score, and how is your payment history and credit report? If you are a sole proprietor, your personal credit score will be an especially important factor in determining whether you can get financing. When you are just starting your own business, this will be the basis a potential lender will use to evaluate your capacity to repay a loan or credit.
Are you willing to provide a personal guaranty for the loan or credit? If you are a sole proprietor you are liable for your business debts anyway. But if your business is set up as a partnership, limited liability company, corporation, or S corporation, lenders might request a personal guaranty from one or more of the partners or owners of the company before granting a business loan. This gives the lender more assurance, especially if the person providing the guaranty has a good credit score and payment history, and perhaps has a history with the same lender.
How Much Do You Have Invested?
Do you have a sufficient amount of your own personal resources invested in the business? It is normal for lenders to expect owners to have their own resources invested in the business. This shows the lender that the owner is taking the business seriously and trusts in its chances for success. The amount of capital the owner should have invested will depend on the nature and size of the business, but it is reasonable to anticipate that lenders will expect the owner to have contributed at least 10% of the business capital.
Do you have experience in managing your own business? If you are starting out with a business of your own for the first time, it will be important to show potential lenders that you have professional experience, expertise, and skills in the business you are undertaking. Your entrepreneurial skills may not yet have been tested, but you should be prepared to convince potential lenders that you are capable of managing the marketing, commercial, financial, and administrative aspects of doing business.
Can Your Business Repay the Loan?
This is the real question lenders want answered. If yours is a business with demonstrated profitability and a proven record of making payments on time, you have a very good chance of obtaining financing. If your business is not yet profitable, you will have to make a convincing case of how you intend to turn things around.
When you are just starting a business, it will be important to provide as much data as possible about businesses comparable to yours, or industry statistics that show that your business can generate the income and cash flow necessary to be able to make the payments.
Does your business have any property it could place as a guaranty of payment of the loan? Lenders want certainty with regard to your ability to repay. Property pledged as a guaranty gives them more certainty in the event you are unable to make the payments. So any business property you place in guaranty will considerably increase your likelihood of obtaining financing.
How Much Debt does Your Business Already Have?
When a business has too much debt, its earnings and its cash flow go toward making payments on the debt and are not available for reinvesting in the business to generate more income. This can affect your ability to continue making the payments on already existing loans. Therefore, it will be more difficult to obtain even more loans. You should keep your debt to equity ratio as low as possible, without losing the leverage that may be beneficial or necessary for your business.
In order to obtain financing, you should have a clean record in the sense of having filed and paid all your personal income tax returns and those of your business. If you are an employer you must have paid all your social security and Medicare taxes, federal and state unemployment taxes. You must also have paid all local property taxes, and any other fiscal obligations.
By evaluating these different aspects, and trying to objectively answer these questions, you will have a much clearer idea of your financing needs and will be much better prepared to answer the questions a potential lender may ask. You will also feel more confident, you can look for the most appropriate sources of financing, and will be able to obtain the most effective and efficient financing conditions for your particular business.