Business financing is often necessary for small businesses to grow when they lack the income or capital to expand on their own. But it’s important to understand the risks of taking on business loan debt.
Without a thorough understanding of how small business financing works, you could lose assets or damage your finances. Learning the risks of financing a small business and how to manage it effectively can prevent you from taking on too much debt or defaulting on your loan.
Key takeaways
- Small business financing is essential for growing a small business
- Several risks come with financing a small business, including personal liability and an impact to your credit score
- There are many types of small business financing, making it easier to find the best financing option for your business, reducing the risks
What is small business financing?
Small business financing means taking on debt for your business. Financing for a business can include a business credit card, line of credit, cash advance or a loan. The types of business loans or funding that work best for your company depend on factors like the amount of financing you need and how fast you need it.
| Type of small business financing | Description |
|---|---|
| Business credit card | A credit card to use exclusively for business purchases and to build the company’s credit. |
| Line of credit | Provides access to a lump sum loan amount you can draw from and only pay interest on the borrowed money. |
| Merchant cash advance | Provides a lump sum advance based on future debit or credit card sales. |
| Term loan | Provides a lump sum amount to the business with level repayments required over a period of years. |
| SBA loan | Secured and unsecured loans that are government-backed by the Small Business Administration. |
| Invoice financing | Uses unpaid client invoices as collateral to advance a lump sum to the business. |
Advantages of financing a small business
Understanding the pros and cons of financing a small business can help you decide if financing is right for you. These are some of the advantages to consider.
Receive startup funding
Some business owners require outside capital just to get started. A small business loan offers a lump sum that they can use to fund initial investments. Some banks will give you funding even if you’re new, but other small business lenders require some business experience first.
Once you get your company off the ground, it will get easier to raise capital, especially if you make on-time payments.
Expand operations
Startup founders aren’t the only business owners who reach out to lenders. Companies can grow their market share by borrowing money from financial institutions. For instance, a restaurant owner can take out a small business loan to set up a new restaurant. This additional location makes it easier to serve more customers and gives existing customers more options.
You can also use a small business loan to hire more workers, increasing your capacity to serve more customers. A loan can help with wages, and you can repay the loan with the additional profits that your company generates.
Buy assets
Small business owners can use small business financing to buy additional assets. Truck fleet owners can take out equipment loans to finance truck purchases. That way, they’re not stuck with endless lease payments and can serve more customers.
Construction companies may need loans to obtain the necessary materials for a project. These companies need the materials before receiving payments since customers only pay in full when the job is completed. Loans give construction companies the flexibility to get the materials they need before completing the job.
Maintain good cash flow during slow seasons
Seasonal businesses like beachfront hotels need cash during the slower months to fund operations and continue to provide their services. Even if businesses shut down during slower seasons, they still have to incur some fixed costs, such as rent and utilities.
Small business financing gives these companies the extra cash they need when revenue dips. This capital also gives seasonal businesses the resources to prepare for the busiest months of the year. It’s better for these businesses to be fully prepared during the peak months than it is for them to be scrambling because they didn’t have enough funds to get a headstart.
Risks of financing a small business
Before you take out a loan or other form of business financing, you should understand the risks involved in taking out business loan debt.
Liability
Some business loans require a personal guarantee, which means your personal assets could be at risk if you fail to repay the loan. Small businesses and startups that aren’t yet established and lack a positive repayment history can also face this liability issue if they choose to take out a personal loan instead of a business loan.
If the business fails and has to shut down, you could also be personally liable for the rest of the loan. By not taking on too much debt initially, you can allow your business to grow so your income stays in line with your outstanding debt.
Business credit risks
If you take on too much business loan debt, your personal or business credit score could suffer if you can’t make reliable repayments. Taking on debt from multiple sources is an easy way to become overextended, creating a greater chance of missing payments or defaulting.
It can also make you seem more risky to lenders, who will be less likely to provide financing in the future. While bad credit business loans are available, the terms are often less favorable, costing your company more money in the long run.
Interest rate changes
A fixed interest rate stays the same throughout the loan term, making payments predictable and allowing you to budget for them more easily. But variable business loan interest rates can fluctuate, making them more expensive and potentially making it difficult for timely and full repayments.
Before signing for a loan, ensure you understand your total cost, including the loan amount and interest. Using a business loan calculator can help you budget for a loan so you don’t overextend yourself by taking out more than you can afford to repay.
Losing collateral
Certain business loans, like equipment financing or secured business loans, require collateral, a company asset that secures the loan. Businesses often use company real estate as collateral, but the equipment or vehicle you’re financing is typically the collateral in equipment financing.
If you default on the loan or have cash flow issues, the lender can seize the company assets you use as collateral. The asset stays in your possession while making timely payments, but if you fall behind, the lender may reach out to make arrangements before repossessing your property. If you can’t make payments, your asset becomes their property to pay off the loan.
How to manage small business financing
Properly managing your small business financing can help ensure you repay the loan within the terms and lower your risk of default. Use these tips to help you manage your business loan financing effectively.
- Make a business debt schedule to ensure you never miss a payment.
- Review all your lending options. Seek out startup business loans if you’re a startup instead of bad credit loans or other financing options that aren’t tailored to new companies and have less friendly terms.
- If you can’t make your payments, communicate with your lender before you miss a payment. There may be options that can help you avoid defaulting on the loan.
- If your revenue allows, you could save on interest by making extra payments.
- If you didn’t get the best terms initially, have a variable business interest rate, or rates have decreased since you took out the loan, consider refinancing. Just make sure the cost of refinancing is worth it.
- If you have too many payments to keep track of, consider a business debt consolidation loan. Consolidating all your loans can make it easier with just one monthly payment.
The bottom line
There is a level of risk with all types of business financing, but putting measures in place can make financing worthwhile, help your company grow and build business credit. Weighing the pros and cons, finding the right financing for your needs and ensuring you don’t over-leverage your business by taking on too much debt can help ensure success.
Frequently asked questions
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It can be hard to get business financing if you’re a new business and lack a business credit score, cash flow or payment history. The industry you’re in, the type of collateral you have and the amount of debt you already have also factor into how hard it might be to get business financing. The better your business credit, payment history and cash flow, the easier it is to get funding.
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If the business fails, what happens to a business loan depends on the type of loan. Unsecured business loans usually require a personal guarantee, meaning the lender can seize your assets to satisfy the loan terms. With a secured loan that involves business collateral, the lender can repossess the property you use for collateral. If there is a remaining balance, the lender could still come after you personally for the rest.
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Taking out any business loan is risky. But if you put the proper measures in place, like having a repayment schedule, making extra payments when possible and communicating with your lender if you can’t make a payment can reduce your risk and ensure you repay the loan.
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