There’s been a lot of movement with interest rates over the past year, and it’s tough to predict where they will go next. If you’re wondering whether borrowing for your business makes sense now, you’re not alone.
Here are six questions to ask yourself to determine if it’s a good time to borrow.
1. Do I really need to borrow now?
Suppose you need funds to obtain new equipment to continue operating efficiently — or need additional resources to keep up with demand and maintain service levels — then yes. In that case, it may make sense to borrow for your business. Assessing your needs, including how much money you need to borrow and over what time frame, can help ensure you don’t borrow more than necessary and over-spend on interest costs.
2. Can my current financial situation support more debt?
How leveraged are you right now? If you’re questioning whether borrowing is the right move now, look at your Debt Ratio. Your Debt Ratio shows the percentage of your business assets financed by creditors. It’s a ratio lenders will look at before lending money to your business, so it’s wise to know this number when considering borrowing.
How to calculate Debt Ratio +
Divide your total debt by your total assets. A good Debt Ratio largely depends on your industry, but anything below 0.3 is considered fair. With anything above 0.6, obtaining additional loans may be difficult — and perhaps a signal that it may be best to wait to borrow until your debt decreases.
3. Am I confident my cash flow can absorb additional debt?
It costs money to borrow money. Whether you need to make principal plus interest payments or interest-only payments to service your debt, you’ll be on the hook for a regular cash outflow. Is this something you can afford? If interest rates were to increase further, would you still be able to cover your payments comfortably?
If you need, take a moment to calculate your Debt Service Coverage Ratio (DSCR). This is a key measure of your ability to repay your loans, take on new financing and make dividend payments.
How to calculate your Debt Service Coverage Ratio +
To calculate DSCR, divide your net operating income by your debt service, which is the sum of all current debts, including principal and interest. As you evaluate your DSCR, keep in mind your medium- and long-term cash flow projections — you’ll want to feel comfortable that your ratio can remain strong in the foreseeable future. Typically, the greater the value over 1.25 (125% coverage), the better.
Remember that some lenders calculate DSCR differently, so it’s important to have a conversation with your lender to understand their methods, including the treatment of corporate distributions in their calculations.
4. Will borrowing pay off for my business?
Your decision to take on debt needs to pay off over the long term. The cost of borrowing should typically be lower than the returns generated by the investment. How confident are you that you’ll realize enough growth if you borrow to grow your business? Do you have orders ready to be locked in? Are you making strong headway into new markets? Be sure to create projections and scenarios to understand the impact of new revenue and expenses, including your borrowing costs.
“We speak frequently with companies about their growth plans,” explains Rebecca Vendersleen, Senior Relationship Manager, Commercial Financial Services, RBC. “Sharing your projections with your bank can be a great starting point to see if debt financing makes sense. Don’t forget to highlight how you developed your projections – including any key assumptions, sensitivity analysis (if any), or vital contracts you’re working on.”
5. What type of credit is best for my business objective?
Whether you need access to funds over a period of time or just a one-time sum of money will determine the type of credit you use. For example, if you need funding to cover staffing costs until you start to collect sales revenue, or you need to purchase more inventory to cover increasing demand, an operating line of credit may make more sense. If you need a piece of equipment, a Term loan may be best.
If you’re borrowing for equipment or a vehicle you need, keep its lifespan in mind. If the equipment is expected to last three years, for example, ensure the loan repayment period doesn’t exceed this time frame. You don’t want to continue paying for something after it’s no longer useful.
6. Have I looked into other funding sources?
There are multiple ways to secure the funds you need to run and grow your business. Non-repayable government grants and incentives can provide funding for businesses looking to expand, create jobs, advance innovation, launch environmental initiatives and more. Take a look at our article 5 Ways Grants Can Help Grow Your Business in 2023 for more information about using grants to advance your business.
Also, consider whether you can bring in a partner who can invest in your business or if there’s anything you can sell to grow a more lucrative side of your operations.
Borrowing is often a necessary part of business, particularly if you want to grow. As you assess your borrowing needs, keep in mind your other options for funding, the current and future health of your finances and the expected payoff. And, when you’re borrowing in a rising interest rate environment, it’s important to stress-test your finances to feel confident you can continue servicing your debt should your costs go up.
Speaking with a Business Account Manager can help you gain the clarity and confidence you need to make the borrowing decisions that are best for your business.
This article is intended as general information only and is not to be relied upon as constituting legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. Information presented is believed to be factual and up-to-date but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by Royal Bank of Canada or any of its affiliates.