Optimal Approaches for Small Business Funding

With rising interest rates and an increase in predatory lending practices targeting small businesses, it’s more important than ever for small business owners to understand lending options and best practices for obtaining funding from banks and other lending sources. Predatory lending practices are common in borrowing, credit, and finance services. They involve the imposition of arbitrary terms with fraudulent and unfair practices on the borrower, exposing the borrower to financial risks in exchange for obtaining the loan. Common predatory and other risky lending practices that small business owners need to be aware of include:

• Asset-based lending and equity stripping: collateralized loans that are secured by businesses’ or owners’ assets rather than the ability to repay the loans. Such assets are at risk in the event of a default.
• Loan flipping: refinancing existing loans with new loans with higher interest, which results in a larger loan liability.
• Balloon payments: a loan with low monthly repayment but with a substantial payment at the end of a loan’s term.
• Excessive fees: fees added to the loan’s interest rate, resulting in a larger financial burden. An outsized origination fee or repayment practice, for example, leaves the principal of the loan uncovered and the funds directed only toward repayment of interest.

Reasons for Obtaining Funding from Lenders

Businesses generate and use cash in three main activities: operations, investments, and financing. The following are some of the instances where additional funds may be needed beyond what the cash flow can provide:

• Expansion that requires additional investment in assets.
• Rapid growth that requires additional capital.
• Slowdown in business that leads to a deficit of funds needed to cover necessary short-term expenses.
• Seasonal businesses that require extra funding during the offseason to remain operational.

 The sources of lending fall under three categories, according to The CFO Guidebook:

• Asset-based financing: The asset of the business is used as collateral. Examples include inventory financing, factoring, line of credit, and leasing.
• Unsecured financing: The reliance is on cash flow to facilitate repayment. An example is long-term loans.
• Guaranteed financing: The debt is guaranteed by a third party, such as a government entity.

For a small business to obtain a loan, it’s advisable that it has steady cash flow and earnings. If a business has variable cash flow and earnings, it may not be able to pay back the lender. Most forms of lending are limited and based on the value of the collateral. If the funding needs surpass what the business can obtain by traditional means, it may be necessary for small businesses to obtain personal guarantees from the business owner.

The best approach is to prepare an annual budget and a strategic business plan for at least three years, including projected income statements, a project balance sheet, and projected cash flow. The projected cash flow will show the expected generated and used cash during the business plan period. It will also determine the needed financing for borrowing during the business plan period.

When considering lending options, one should:

1. Understand the terms and conditions: Carefully review and understand the terms, interest rates, repayment schedules, and any associated fees for each financing option.

2. Assess repayment capacity: Evaluate the business’s ability to repay the loan without compromising daily operations or future growth.

3. Consider the long-term implications: Look beyond immediate needs and consider the long-term implications of the chosen financing option on the business’s financial health.

4. Diversify funding sources: Avoid reliance on a single funding source; diversify to reduce risk and ensure access to alternative options.

5. Consult financial advisors: Seek advice from financial professionals or mentors to gain insights into the most suitable financing strategy for the business.

If you run a small business and you want to get a loan, there’s always homework to be done. You need to prepare a forecasted business plan for the next three years, including an income statement, a balance sheet, and a cash flow statement. You also need to prepare an annual budget for the following year. This will enable you to know the amount of cash that you’ll need to borrow from lenders and its usages. Be aware of not only the funding alternative sources and the pros and cons of each alternative but also the different types of sources. The preparatory phase of evaluating options of lending alternatives is critical, and it’s vital you don’t overburden your business with loans.