By Adam Hoeksema
In order to determine whether or not you should apply for a loan and how much you should ask for, you need to run some numbers. The best way to test is by creating a cash flow projection. There are a number of tools and spreadsheet templates you can use to create financial projections including:
- ProjectionHub – Web based tool that helps you create financial projections
- LivePlan – Business plan software that includes financial projections tool
- EZnumbers – Extensive spreadsheet tool to create financial projections
Once you have a baseline set of cash flow projections you can start playing with some what-if scenarios.
So let’s look at 2 scenarios to determine whether a loan is worth it:
1. Buy Larger Quantities of Inventory – This is a fairly straightforward calculation. Let’s say that right now you are buying inventory in shipments of $1,000 at a time. Each time you have to pay $100 for shipping.
If you were to secure a $25,000 loan to purchase inventory maybe you would purchase one large $25K order. You might get a quantity discount from your supplier of 10%, so you immediately save $2,500. You might also only pay $500 to ship the entire order together which is another $2,000 savings. You are saving $4,500 by ordering in larger quantities, but you will have to pay interest on the loan. Let’s say the loan is at 10% interest for a 12 month term because your small business is relatively risky. For the life of the loan you would pay $2,500 in interest, but the cost savings makes this a no brainer. Ultimately, you end up saving $2,000 which makes this loan worth it!
2. Advertising for the First Time – Now let’s say you want to take out a 12 month $25,000 loan at 10% in order to advertise your product through Google Adwords. This is the first time you have ever used Google Adwords to advertise your product which makes this situation very risky. Let’s assume you make $50 of gross profit on each item sold. Since this is your first time advertising you can’t know the average cost of customer acquisition. Let’s say Google charges you $1 a click and you only convert 3% of visitors into customers.
So for $25,000 you would get 25,000 website clicks and you would convert 750 into customers. You would make $37,500 in profit ( $50 x 750 ). But you paid $25,000 + $2,500 in interest for the life of the loan. Again, in this situation it would be worth it to take out a loan, but if your conversion rate went down to 1.5%, you would only make $18,750 which would make advertising a terrible use for the loan funds.
When you are looking to secure a loan for your small business, make sure to run through various scenarios. If you aren’t sure whether you will be able to make a profit from the loan, then you should do more testing and analysis until you are certain the loan is worth the risk.
About the Author: Adam Hoeksema is the Co-Founder of ProjectionHub. ProjectionHub is a web application that helps entrepreneurs create financial projections without the need to have a PhD in spreadsheet modeling.