Financial Literacy: How to Borrow Money Wisely

by Craig Anthony

3 min read

A natural part of running a business is raising funds to support operations. Although taking out a loan can be greatly beneficial for an entity, there are a number of factors to consider to be sure the loan is wise and your business is set up for success in the future.

How Much to Borrow

Each company has different cash flow and operating needs. This largely depends on the size of the company, ambition of its operations, and the industry in which it presides. Therefore, when determining how much money to borrow, customize your forecasts around the position and direction you expect to be in the future. Be prepared to support your request with substantiated evidence as this information is typically required by financial institutions.

Utilize financial metrics to assist with finding the right dollar amount. This narrows down the dollar range that your business actually needs. For example, establish a target calculation for the current ratio. Say you wish to maintain a current ratio of 2.0, with current assets of $80,000, and current liabilities of $30,000. Your current ratio is 2.67, and by taking out a loan, your current ratio decreases. If a loan of $20,000 is taken out, your current ratio decreases to 2.0, or $100,000 / $50,000. Therefore, calculate a range of metrics to determine a comfortable number.

Credit Score

Your credit score correlates with how easy it will be to be receive a loan and the corresponding interest rate. Higher credit scores, above 700, receive lower rates and more financial institutions willing to establishing an agreement. An individual’s credit score is evaluated based on payment history, amount owed, length of credit history, new credit, and type of credit used.

Free online credit score reporting applications do not actually pull an individual’s real FICO score. Instead, these programs project an estimated rate based on a number of variables pulled from an individual’s profile and produce a FAKO score. The only way to receive an actual credit score is to contact any of the three official credit bureaus. Because your credit score from the actual bureaus is used when establishing a loan, be aware this number may be different than what you’ve seen online.

Timing of Loans

From the perspective of a lender, issuing a loan is risky. Although a loan creates a legal obligation for a borrower to pay, there is still the risk the borrower will default. For this reason, the timing of when a loan is made in the life of a business changes numerous variables. When a business is in its startup or youth phase, the bank incurs a higher risk. For this reason, a younger business should expect higher interest rates, more restrictions, and lower approved credit lines. In addition, a business without an established market presence, consistent business results, or historical financial information to reference will experience higher turn-away and find it more difficult to receive loan offers.

Shopping Around for Loans

Attempting to secure the best rate and conditions for a loan may result in unfavorable side effects. Hard inquiries negatively affect your credit score, especially if numerous inquiries are made in a short period of time. Although the inquiries regarding certain types of loans such as mortgages or car loans are not as stringent, be mindful that shopping around for loans can negatively impact your credit score. Independently collect information from a financial institution’s website to narrow down your options and minimize your recorded search.

Risk Profiles

There are general elements of a loan that result in higher interest rates. This is because the risk profile of the debt is higher, and financial institutions compensate for risk by assessing higher interest rates. Loans of longer duration or higher dollar amounts are assessed higher interest rates. A number of external factors including prospective inflation, the currency’s stability, systematic market risk, and political risk also affect the borrowing rate.

Debt Convenants/Restrictions

To ensure an entity is responsibly using the proceeds from a loan, a financial institution may implement debt covenant restrictions. These items are built into the loan agreement and place financial obligations onto the business. For example, a loan covenant may require a current ratio of 2.5. If the financial metric of the business dips below this amount, the interest rate may increase, the credit line may decrease, or the entire loan may be callable as immediately due. When borrowing funds, ensure compliance with prior debt covenants and ensure future covenants are attainable.

Financial Literacy

What does an amortized interest calculation mean? Is your assessed interest rate real or nominal? Knowing small details before taking out a loan can prevent future misunderstanding and unfortunate business circumstances. It is important to increase your financial literacy prior to reading a debt agreement and developing questions to ask a financial institution.

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