Is taking business loans a good idea?

The answer is most likely yes but will definitely depend on what are you using the loan for.

A business loan must be a productive loan, the reason for taking a loan is to further the wealth generating power of the business.

There are two main types of business loans, installment and revolving loans.

Installment loans should be used to buy productive assets, and the size and term must be determined by the type of asset to be acquired. Say you are buying a car, the suggested term will be no less than 3 and no more than 5 years, most likely 4 years. Some of the reasons to buy a new car for the business is to have more millage per gallon and less maintenance costs. If you keep the car for more than 60 months, this advantages will start fading away.

Same logic applies if you are thinking of purchasing equipment, you’ll have to ask yourself: for how long will you keep the machine? How fast does this type of equipment become obsolete? Depending on the type of machine the answer will be around 3 to 10 years, most common terms being 5. For buildings the term most likely be around 7 to 10 years.

Now comes the cash generating capacity of the asset to be acquired, when deciding on taking a loan one must ask two questions:

1. Is the cash generated or saved by the asset to be acquired enough to pay for the loan?
2. If the acquired asset does not do as expected, can the cash already generated by my business pay for the loan anyway?

If the answer to both questions is yes, then the clear answer for purchasing the equipment and taking a loan for ti is a clear yes. If the answer to the answer to the first question is no, then you should reconsider not only the loan but the value of acquiring the equipment.

If the answer to the second question is no, do not consider the loan to be a bad idea just yet but be clear that this is a new project, treat it as such. Ask yourself a few more questions:

1. Should this new project be a part of my current business or is it a new business?
2. Should I share the risk and rewards and find a new business partner?
3. Will I be risking the current business because of this new project?

There is no clear answer to those questions and will definitely depend on your risk aversion.

Revolving loans are good for helping the business cashflow and should not be used to purchase equipment, they should always be used to help short term (no more than 180 days) cash needs such as financing clients and supplier’s discounts. The proper use of revolving loans requires to frequently take and pay the loan. Revolving loans will most likely have annual fee which you can think about as a “cash flow insurance”.

The fee is relative of the size of the revolving line of credit, so it is always a good idea to review the possible opportunities (financing clients or purchasing extra inventory) before deciding on the size of the revolving loan.

Considering you have some kind of credit worthiness assessment for your clients, then the remaining question to be asked to determine the suitability of the revolving loan is: Will the profit for financing the clients or holding on the extra inventory be larger than the interests and commission paid for the loan?

If the answer is yes, then the use of the revolving line of credit is a good idea.

If the loan to be taken for purchasing the business owner’s the new toy (fancy car, beach house or shiny new office) then the business loan is most likely a bad business idea. Toys should be bought with cash surplus.