Role of Loans for for small businesses.

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Let’s talk about the role of loans for small businesses.

 

In most part of India, leverage (loan) is considered bad. Maybe this is because of our culture and social norms. However, in the modern era, this thought process is slowly fading away. Most of the young generation entrepreneurs have a different view towards leverage. They like to take more risks, explore opportunities, and chase their ambitions.

If we look at this from a financial perspective, a loan is neither bad nor good for business. Everything depends on how you manage it!!

 

Now, let us discuss when we can say leverage is not bad for your business. Certainly, this is not so simple as it seems,

1)    Borrow money for your business only when you see a growth opportunity to be funded

If you are planning to take up an order which is more than 3 times your routine capacity to serve, you need both capex and opex cash to fulfil it. I cannot precisely give you how much you should borrow, as everything depends on the size of your P&L, cash generation cycle, repayment risks, etc. Always weigh both the collection capacity of your invoices and the practical requirement of cash to manage a big order. Certainly, you need to assess

A)   whether such an order is recurring in nature or one-time?

B)<font face="Times New Roman" size="1"> When</font> will you be paid for the fulfilment of such an order?

C)   Will you get any advance or not from the customer?

D)   Can you manage it without much capex spend or not?

 

The more honest you are about these questions, the better decisions you will be able to make about borrowing.

 

2)    Working capital requirement, which can be repaid within the next 1 quarter

Most of us know that SME segment companies always borrow rolling credit lines, which are used for fulfilling the working capital requirement. Banks also charge interest based on your cash generation capacity.

But very few know how to get rid of these working capital loans and use the same capital for expansion and innovation.

If you have a business plan which mandates you to expand your business geographically, vertically, or horizontally, it is best that you start thinking about reducing your working capital borrowings. Because this kind of loan will never help you grow. Even if it does, the growth rate will be very slow. It is a vicious circle to get in!!

 

3)<font face="Times New Roman" size="1"> One-off</font> expense which requires additional capital than your routine.

One-off expenses could be a variety of things. From opening a new branch to purchasing new machinery to changing your marketing strategy. Everything requires a reasonably good amount of capital. Self-built reserves are always the best source to fund such one-off items. But in most cases, SMEs fail to manage their cash and fail to build a reasonably good reserve which can cater to such needs.

In this kind of situation, short-term borrowings are the only way to go about. Make sure, short-term borrowings are kept and respected as short-term only. Never let them turn into a long-term one, however your banker lures you with offers.

 

4)    Any other cause which is strategically important for your business and has a lot of upsides attached to it.

Any other reason which is important for your business, without which if you feel that your business will lose a big opportunity. Go for leverage. Again, keep in mind that the terms of repayment and usage of such borrowed funds remain for the borrowed purpose only.

 

Now, why is leverage not bad for your business? As long as you manage it well!!

 

a)    Discipline

As every borrowing carries a relevant cost, naturally, it brings a sense of discipline in the borrower to pay it back. You take it seriously and try not to make it eternal for your organisation. Unlike corporates, where the board or governing body analyses, assess and monitors the use of leverage, here all such responsibilities lie with the proprietor only.

b)    Tax benefits

In most cases, the interest paid on loans is tax-deductible, helps businesses to save taxes, and eventually reduces the effective borrowing cost. What it means is if you are borrowing 5.0 Crores and paying interest of 10% on it, you can claim 10% of interest paid as an expense and reduce your profit and thereby reduce your tax on the profits. Opposite to that, your borrowing cost is also not exactly what you see on your loan agreement, because you are getting a tax benefit.

c)    Scaling becomes easy

Assume you have a business which generates cash of 25 lakhs a month after paying all expenses. And you got a big order to supply, you do not want to let it go; in that scenario, you go for external borrowing. Thereby increasing your turnover and profitability. Instead of leaving such an opportunity. Basically, here, the business is growing. But the cost of such growth is very small. Such multiple efforts will help you grow your business organically.

 

d)    No dilution of ownership

Loans do not ask you to pay them back in shares in your company. They will ask you to repay the funds with interest. Thereby, you get to retain your control over your organisation. There are other alternative ways of raising funds, one of which is diluting your ownership in the company and raising funds. Like IPO, convertible notes, etc.

In summary, loans are always double-edged swords. Unless you manage them professionally, they end up leaving a big dent in your financials. Therefore, it is advised to have your work done cautiously before going to any leverage.

You can connect to Guru Gokak: guru.oceanblue@gmail.com