Avoid These 5 Common Small-Business Financing Mistakes
Free Book Preview Entrepreneur Kids: Launch Your Own Business
When taking on financing as a small business, the correct course of action always hinges on answering this question: what am I trying to accomplish?
The thing is, financing decisions don’t exist in a vacuum. Small businesses often miss the vital details when assessing whether to borrow or not, such as the full financing cost, the drain on their time, the opportunity costs and baked-in fees.
The right financing option varies for every company, but there are five areas where I see small businesses frequently make financing mistakes. Here are the common pitfalls and the best ways to avoid them so your small business can choose the best option at each stage of your company’s growth.
Related: How to Raise Money for Your Business
1. Be aware of your real interest rate. Surprisingly often, people who think they know how to calculate interest rates often don’t. I even see journalists from major national newspapers frequently get it wrong.
For example, if you borrow $1,000 and pay $1,100 back over three months on weekly installments, your interest rate wasn’t 10 percent, as simple math would dictate. Taking a closer look at the timeframe for the note and your average principal outstanding reveals that it’s actually closer to 80 percent. That’s a difference of 70 percentage points in your financing cost.
This mistake happens because most businesses simply calculate APR as total fees divided by the amount borrowed, rather than calculating the interest based on the amount outstanding at every point in time (i.e. the amortized amount). The difference is massive for small businesses as financing mistakes are compounded. In the example above, the actual annual rate is eight times higher than the optical.
2. Pay attention to hidden fees. When taking out financing you must take into account origination fees. Many lenders charge origination fees of 3-4 percent, which are deducted from the loan amount. Depending on how quickly you pay that loan back, that fee can have a large impact on the true interest rate you’re paying.
A $30 fee on a $1,000 loan is really a 3 percent fee upfront that will significantly skew your real APR, especially for short-term loans. It’s very similar to ATM fees that seem like a small amount, but can cost you big over the long-run.
When borrowing money, be aware of the fees that accompany the capital infusion: administrative fees, application fees, contract fees, due diligence fees and more. These fees are sometimes hidden in the fine print, so comb through everything carefully before moving forward.
3. Treat opportunity cost like a real cost. Banks routinely take up to two weeks to review a loan application and, if approved, another 15–60 days to fund the loan. For executives running a business, that’s time they could have spent generating sales and growing the company. The lowest APR doesn’t always provide the best financing option when you take into account the loss of time spent elsewhere.
The adage that time is money still holds today. Look for lenders, online and off, that can move at the speed of today’s business and expedite the application process so you can spend your time making money, instead of jumping through hoops to borrow it.
Besides the opportunity cost of your time, also consider the cost of timing. If you’re looking to take on additional work or buy inventory, the timing of a bank loan may or may not work out.
Related: Cut Your Financing Costs
4. The intangible costs for smaller or short-term loans can be greater than interest. The loan amount and pay period matters a great deal. Often, companies in need of working capital are borrowing smaller amounts and paying it back over shorter periods of time than traditional, long-term loans. These need to be approached differently than longer-term loans for large amounts.
In these instances, the actual interest rate can be the least important consideration. Since the amount sought is small and paid back rapidly, such financing wouldn’t accrue the large amortization costs common in loans of six months or longer.
Sometimes, costs outside of the actual loan should take priority. For example, if you pay a bookkeeper $50 an hour to work on processing a loan for two hours, that’s $100 that needs to be assessed on the total cost of the loan and is often a greater cost than the interest itself. Too often these costs are completely overlooked.
Don’t let the small size of the loan fool you. Taking a comprehensive approach to assessing all costs -- associated fees, parties involved and period of payment -- will pay off huge dividends.
5. People are financing without knowing it. Financing occurs far more often than we realize. Giving your customers a 2 percent discount for paying within 10 days rather than 30 days is really a 2 percent finance charge equivalent to a 73 percent APR.
In another scenario, if you’re offering your customers a 10 percent discount to pay immediately or pay full price on Net-30 terms, you may have a better alternative. The alternative would be to get financing which may cost you 4 percent for the month and then receive the full payment in 30 days. In this case, financing saves the company 6 percent. This is how thinking about discounts as financing will pay off in the long run.
Similarly, if you let customers pay you with a credit card, you are essentially incurring a 3 percent financing fee to grant them 25 days to pay, since that is the “float”, or grace period of most credit cards. That is almost a 50 percent APR. Take a closer look at accepting credit and debit cards to ensure it’s the right approach for your business.
For how important financing is to new companies, it’s too frequently misunderstood. With a better understanding of the factors outlined above, you might find some much-needed change, or even dollars, you didn’t know were there.
Related: A Basic Guide to Bank-Term Loans