3 Keys to Finding the Perfect Small-Business Loan

When I first started in the banking industry as a lending officer, we had older loan officers who grew up in the days where banks had one type of lending tool available to you. It was a term loan using what is known as the “rule of 78s” to determine interest payments.

Today, banks and even bankers within banks have become quite specialized. As a business owner it is easy to become overwhelmed by the types of lending tools available.

The good news is there is probably a loan that meets your specific business needs. The bad news is when you get pigeon-holed into the wrong type of loan your business is likely to suffer.

When I train business owners, I often suggest they match the type of loan to the asset being financed. There are several principles that ensure the loan you choose is appropriate to the business need you're trying to meet. 

Principle 1: Use short-term financing for short-term needs. For example, if your company is feeling pressure from growing its accounts receivable you should seek a bank, factoring, or asset-based line of credit. These types of credit facilities are revolving, and the loan balance normally moves up or down depending on the asset (usually accounts receivable). By definition, a short-term asset has a life of less than 12 months. Short-term debt is debt that is paid off within 12 months.

In my way of explaining this strategy, I help business owners understand that you finance short-term assets (accounts receivable and inventory) with short-term liabilities (loan of less than 12 months to maturity). Using this method nearly always results in the least cost to the borrower, and more importantly it keeps you out of trouble.

Trouble happens when you use long-term loans to finance working capital or worse, use working capital to pay for long-term assets. This brings me to my second principle.

Principle 2: Finance long-term assets with loans that have maturities that match the useful life of the equipment. I met with a business owner last week who has a very successful medical practice. He has a great market, unlimited patients, and has built a very profitable formula for success. During the last several months he made the decision to consolidate three offices into one. He rented the new space, moved all his medical equipment, put in a VOIP phone system, put in state of the art scheduling and practice software, and ordered about $50,000 worth of new outdoor signage.

The day I was in his business he had wall to wall patients, and he had put in processes that got his patients in and out with the minimum of time and cost. From an operational standpoint, things couldn’t be better.

He called me because he was in desperate need of working capital. I couldn’t understand why he needed working capital until he told me he had spent the $50,000 for signage out of working capital, had done all his equipment moving and leasehold improvements out of working capital, and had bought several new pieces of equipment out of working capital. All of the improvements he made will pay off over the long run, but he shouldn’t have used working capital to buy these long-term assets and leasehold improvements.

What he should have done was line up a five- or seven-year long-term loan to pay for all the new equipment and leasehold improvements. He needed to save his working capital to pay his 40 employees and nine doctors. Though it is not impossible, it is going to be much harder obtaining a loan to pay for the consolidation costs and leasehold improvements after the fact than if he had arranged the financing beforehand. I explained to him that given the slowness of area banks right now, he should be prepared for a loan request to take six to eight weeks to be approved.

This business owner learned a painful lesson: Don't buy long-term assets out of critical working capital that he needs for payroll and supplies.

Principle 3: Sometimes you have to ignore Principle 1 or Principle 2. What I am saying here is that every once and a while I find a business that needs permanent working capital. The term "permanent working capital" means that you need a sum of money that needs to stay in the company for the purpose of paying short-term debts only.

A business should only resort to using a long-term loan to provide working capital when it has exhausted all other avenues for providing short-term debt. The problem with using a long-term loan for short-term purposes is 1) the cost of borrowing is higher, and 2) if you need more working capital you probably can’t go back to the lender to ask for more until the loan is a couple of years old.

Companies that use this strategy should be prepared to pay off their loan as quickly as possible while keeping as much money available for working capital as possible.

Sam Thacker is a partner in Austin Texas based Business Finance Solutions and Texas PEO Group.
Direct email: sam@bfs-usa.com
Twitter: SMBFianance