Borrowing: The Good, The Bad, The Ugly

Borrowing: The Good, The Bad and The Ugly

Borrowing: The Good, The Bad, The UglyAccording to the March 2019 NFIB Small Business Optimism Index, more than half (51%) of owners reported that they weren’t interested in a loan.

But companies need to borrow money from time to time and should think about how a loan can impact a business and its owners.

The good

There are some compelling reasons why it makes good business sense to borrow money.

  • To raise capital that is needed for expansion and growth. If a company wants to introduce a new line of products, expand to a new location, do research, or engage in other activities to grow, a loan can provide the capital that’s needed.
  • To provide working capital. If a business needs to pay suppliers or other expenses and is having difficulties with cash flow, a loan can help to smooth out the rough times to ensure sufficient cash on hand to pay bills. Of course, a business must have the financial wherewithal to qualify for a loan; the midst of a cash flow crisis isn’t the time to apply.
  • To reduce an owner’s personal investment. If an owner has put his/her own funds into the business (e.g., used home equity dollars or borrowed from a retirement plan), a business loan can be used to repay the owner some of this investment.

The bad

Loans entail some downside to consider:

  • Repayment. Borrowing means having to repay the principal, plus interest. Typically, this must be done on a monthly basis. So repayment is a drag on cash flow.
  • Interest cost. Borrowing money isn’t free; there’s an interest cost to consider. In today’s interest rate environment, the cost is not too high (higher, though than in previous years). However, looking ahead, as the Federal Reserve continues to raise the Fed Funds Rate, expect to pay more for commercial loans.
  • Tax write-off limitation. In broad terms, a deduction for interest expense is limited to 30% of the business’ adjusted taxable income. However, there is a small business exception: those with average annual gross receipts below a set amount (e.g., $26 million in 2019) can deduct all of the interest payments.

The ugly

Loans can turn out to be very bad mistakes in some situations. This can result in:

  • Personal liability for owners. Typically, small business owners must personally guarantee loans to the business. If the business defaults, the owners are on the hook for the balance and the lender can look to their homes, cars, and other personal assets for satisfaction. For example, SBA loans require any owner with a 20% or more interest in the business to give a personal guarantee.
  • Bankruptcy. The ultimate disaster for a business that cannot meet its obligations and has liabilities exceeding its assets may be to file for bankruptcy. This is a costly and cumbersome process.

Resources

If you’re looking for a loan, here are some resources to help you find one:

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