When Borrowing Helps, and When It Hides a Broken Model
Part B: Understand the Money
The best business mindset in the world will not fix bad margins.
Imagine two owners sitting in the same bank lobby, each asking for $10,000. The first wants a piece of equipment that will let his crew take on work they now turn away. The second wants to cover payroll because the last three months did not add up. The bank may treat them the same. But they are asking for very different things.
One is borrowing to grow something that works. The other is borrowing to hide something that does not. We see owners drift from the first situation into the second without noticing, and it is a hard slide to reverse.
What the money will actually do
Before any loan, ask what this money will buy and how the business pays it back. Approval is the easy part.
Borrowing helps when the money buys something that produces more money than it costs. A made-up example: say a contractor borrows $10,000 for equipment, and the payment is $400 a month. The equipment lets him do jobs he cannot do now, and those jobs add $1,500 a month in profit before the payment. After paying the loan, $1,100 is left over each month. The debt is working for him, and he can point to exactly where the repayment comes from.
Borrowing to bridge a timing gap can also make sense, when there is a clear source of money about to arrive. If a customer owes you a large payment in sixty days and payroll is due in thirty, a short-term bridge, such as a line of credit (a borrowing limit you draw on and repay as needed), is a different thing than a loan to keep the lights on indefinitely. Even so, ask whether a deposit or better terms would have prevented the gap. That is covered in Deposits, Payment Terms and Collecting Money Faster.
When borrowing hides the problem
Now the second owner. Suppose every job he does loses $500 after materials, labor and overhead. Twenty jobs lose $10,000. A $10,000 loan feels like relief, and it is, for a moment. But the loan did not fix a single job. Next quarter the hole is bigger, and now it has interest on it. Ask for the total dollar cost, not just the monthly payment. Short-term products like a cash advance against your card sales, or a card balance you carry month to month, are easy to get when cash is tight and can cost far more than a bank loan. Have your accountant check the real rate.
Hold onto this: a cash shortage is not always a cash problem. Sometimes it is a pricing problem, a cost problem or a volume problem wearing a cash costume. If the model loses money, borrowing simply lets you lose it for longer.
Signs to be honest with yourself about: you borrow to pay for last month’s expenses, you take a new loan to make payments on the old one, your margins are thin or negative and you have not looked at them lately, or you cannot explain in one sentence how the loan gets repaid. If any of those fit, stop and look at the numbers first. Gross Margin Versus Net Margin is a good place to start, and so is Fixed, Variable and Semi-Variable Expenses.
Do you know what one job really earns after all its costs? If the answer is no, that is a better use of this week than a loan application.
Professional checkpoint: Before signing any loan, ask a qualified attorney or accountant in your area what you are personally responsible for, including whether you are being asked to sign a personal guarantee (a promise that you, not just the business, will repay the loan), what happens to your personal assets if the business cannot pay, and how the repayment terms fit your cash flow.
A short test before you borrow
- What exactly is the money for, and what will it produce?
- How much extra money per month will it create, in plain arithmetic, and is that more than the payment?
- If the result is half as good as I expect, can the business still make the payments?
- Have I looked at pricing and costs first, in case they are the real problem?
- Do I have a reserve, or would this loan be my reserve?
That last question matters. A cash reserve is usually cheaper and safer than debt as your first line of defense.
Before you talk to a lender
If you have any debt now, write down each loan or card balance: what it was for, the monthly payment, what it costs in total, and where the money to repay it comes from in the business. If you are considering new debt, run it through the five questions above on paper before you talk to any lender.
About two to three hours to list your debts and work through the test. It costs nothing. A conversation with an accountant or attorney before signing may cost something, and it is usually worth asking what that will be up front.
Is any debt you carry today buying growth, or buying time?
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