Advantages and Disadvantages of Borrowing Money From the Bank
People who want to start a business but do not have the financial resources to do so often approach banks to borrow money. Established businesses also turn to bank financing, at times, to expand their company, purchase new buildings or assets, develop new products or cover other major purchases. Bank loans have pros and cons relative to getting money from investors.
Borrowing money from the bank is one of the simplest ways to get needed funds to start or grow your business. By offering a building or assets as collateral, you can often get low interest rates. Plus, the interest is often tax deductible as a business expense.
If you are a sole proprietor, you typically get the loan based on your individual qualifications, such as income and credit history. For partnerships or corporations, banks loans are generally based on business debt-to-income ratios and other financial considerations. Getting a loan with a reasonable rate and using it to increase your customer base or to ramp up product quality can bring a major return on investment.
With equity investment, you do not have the pressure of owing someone principal and interest. However, you also lose some of your business control. Banks assume no control over the way you operate your business just because you borrow money. All they need to know is that you are meeting your loan repayment obligations. If you want to exercise your creative vision without input from other investors, bank financing is the way to go.
Bank loans do bring a longer-term commitment than shareholder investment. You only have to pay back investors if the business earns money. Banks expect their principal and interest payments every month, on time, whether you make money or not. If you fail to make timely payments, your personal or business credit rating slips, limiting your borrowing power in the future.
Having bank loan commitments on your balance sheet increases your debt-to-asset and debt-to-equity ratios, making you less attractive to new creditors as well as potential investors.
Another problem with borrowing money from the bank to grow your business is that it hampers your monthly cash flow. Over the repayment period, you commit a certain amount to repaying your debt. While the funds may help you expand initially, the debt obligations can make it difficult to keep up with monthly expenses and debt while also trying to generate cash and profits. Companies that become too leveraged with debt often get mired in stall mode for years. Plus, if you do not have adequate funds for marketing, it is difficult to attract and retain customers.