I was recently asked to advise someone who was considering taking a=out a loan to start a business. The conversation I had with this person inspired some insights on things you need to consider before taking out a loan. As the facts of the case were given to me the person intended to take a loan of US$1000 which they would pay back in monthly instalments with an interest rate of 15% per month. They were able to part with somewhere between US$50 and US$100 to make payments from current sources of income. They intended to use half of the money to start a business and the other half to attend to some personal needs. The loan was to be collateralised with property. What follows are the tips I had for the person applying for the loan which can be applied to anyone looking to borrow for personal or business reasons.
It’s about Cashflow
Credit and business, in general, is all about cash flow. Simply put the lender will advance money to you and recoup the principal plus interest based on your cash flow. If you are borrowing to fund personal expenditure then it is highly likely that you already have cashflow problems. While I would normally speak from the lender’s point of view I advised the borrower’s point of view. The problem they had on the personal front was a cash flow problem and adding an extra expense (instalments) to their burden was only going to make that problem worse.
The first point feeds into this second point I had. The person said they had US$50 to US$100 available for repayments but this wasn’t tallying with the circumstances they presented to me. They wanted to use half the loan amount for personal expenses which indicate that they had cash flow problems as things stand. What would’ve been a positive sign is them saving that amount regularly making it free cash flow. Of course, a person who has savings wouldn’t need to borrow to start that business. Taking the lower amount of US$50 they could’ve saved up in 10 months to start the business.
Credit in Zimbabwe is not friendly. The loan would’ve required them to pay back US$2800 in total. This is punitive, to say the least. My advice was instead of borrowing and paying back at US$100 per month (the actual instalment amount was US$233 per month) they should rather save up at US$100 per month than start their business. The obvious retort to this was that saving the money is hard to which I pointed out that if that is the case your problem may be a discipline problem rather than a cash flow problem.
T this point I sound I was completely against the idea of taking out this loan. I was not but what I was against were the reasons for taking out the loan. I advised that they should first start their business and after operating for 3 to 6 months consider taking out the loan to expand their business. Starting the business on such expensive borrowed capital is risky. It costs 12 months of US$233 payments (well US$117 if you want t strictly divide it in half because of the use of the loan) which is a lot. Starting the business from savings of US$500 (saved at US$100 a month) is also risky but the risk is limited to US$500.
To get a loan you must prove you don’t need it
I first came across this as a joke but it has turned into one of the most important things I have learnt in finance. When looking at credit we need to be cognizant of the implications going forward and our current capacity. The ridiculously high-interest rate on the loan in the example makes the repayments quite a daunting task. At those rates, you are always better off starting the business from your own capital. The repayments are also indicative; if you can pay US$233 a month then you only need 2 months and change to save up your startup capital for a US$500 business. This all applies if your cash flow is in good stead so think about taking on that burden if your cash flow is not in good stead.
These insights are all based on the financial principles we discuss weekly. I hope the practical example with real-world numbers helps to illustrate these principles in practice.