The disadvantages of small business loans aren't always made clear by lenders who may collect lending interest regardless of whether or not a small business fails. Between 2006-2008 business bankruptcies rose from 19,695 to 43,546 according to the American Bankruptcy Institute (ABI).
Included in those bankruptcies are the approximately 50% of small businesses that are reported to fail within the first 5 years of operation by the U.S. Small Business Administration website (sba.gov). Some of the disadvantages of a small business loan can include 1) loan objective failure, 2) cost of the loan, 3) affect on business credit rating and 4) implication to shareholders.
• Impact on business credit
Creditors use total credit used in relation to total available credit in calculating credit scores. If this ratio is too high it could negatively affect future financing activities for the business. For example, if a line of credit or business credit cards are used to sustain daily operations during the cash conversion cycle and to facilitate accrual accounting, that credit may be negatively impacted by a business loan for another project. When obtaining a small business loan it is a good idea to assess any potential financial impact on other loans or credit.
Creditors use total credit used in relation to total available credit in calculating credit scores. If this ratio is too high it could negatively affect future financing activities for the business. For example, if a line of credit or business credit cards are used to sustain daily operations during the cash conversion cycle and to facilitate accrual accounting, that credit may be negatively impacted by a business loan for another project. When obtaining a small business loan it is a good idea to assess any potential financial impact on other loans or credit.
• Loan non-performance
Small business loans can and do have pitfalls or disadvantages. The business plan which was used to obtain the loan could fail making the cost of the loan higher than the rate of return on the loan. Consumer trends can dip, cyclical markets may stay in downturns, and a long drawn out secular market may lead to potentially unsustainable leverage for a small business. In other words, it may be a good idea to build in a reasonable amount of cash flow redundancy into a small business in case forecasts and otherwise consistent projections do fall short.
Small business loans can and do have pitfalls or disadvantages. The business plan which was used to obtain the loan could fail making the cost of the loan higher than the rate of return on the loan. Consumer trends can dip, cyclical markets may stay in downturns, and a long drawn out secular market may lead to potentially unsustainable leverage for a small business. In other words, it may be a good idea to build in a reasonable amount of cash flow redundancy into a small business in case forecasts and otherwise consistent projections do fall short.
• Cost of loan
Some loans simply are too expensive to be beneficial even if the loan is considered a calculated bridge to a future financial or business goal. This is especially the case with unsecured loans or small business loans with fiscally oppressive terms of agreement. A loan cost that exceeds the return on debt is usually a risky decision unless the loan is implemented in a solid two-step forecast. For example, a seasonal loan that allows a retail business to stock up inventory for the up season or continue operations during the down season.
Some loans simply are too expensive to be beneficial even if the loan is considered a calculated bridge to a future financial or business goal. This is especially the case with unsecured loans or small business loans with fiscally oppressive terms of agreement. A loan cost that exceeds the return on debt is usually a risky decision unless the loan is implemented in a solid two-step forecast. For example, a seasonal loan that allows a retail business to stock up inventory for the up season or continue operations during the down season.
• Implications to shareholders
If the small business has shareholders, the shareholders may be displeased if directors and officers poorly acquire and implement business loan activities. The displeasure of shareholders could have negative consequences to the equity positions within the business or the roles of directors in the business. Some loans may take a complete business cycle to have its desired impact in which case strong reasoning and evidence for the loan may be useful in regard to discussion with shareholders.
If the small business has shareholders, the shareholders may be displeased if directors and officers poorly acquire and implement business loan activities. The displeasure of shareholders could have negative consequences to the equity positions within the business or the roles of directors in the business. Some loans may take a complete business cycle to have its desired impact in which case strong reasoning and evidence for the loan may be useful in regard to discussion with shareholders.
• Faulty risk assessment
If a lending bank is insured against loan defaults they may only apply the minimum risk assessments required to issue a loan and secure debt which may simultaneously increase the risk of loan assessments made by small businesses. This is especially the case for unsecured loans. Unsecured loans don't require collateral, have high interest rates, aren't always offered with borrower scrutiny and are generally higher risk. If a secured loan is risky for a small business, then an unsecured loan may not always be a good choice.
If a lending bank is insured against loan defaults they may only apply the minimum risk assessments required to issue a loan and secure debt which may simultaneously increase the risk of loan assessments made by small businesses. This is especially the case for unsecured loans. Unsecured loans don't require collateral, have high interest rates, aren't always offered with borrower scrutiny and are generally higher risk. If a secured loan is risky for a small business, then an unsecured loan may not always be a good choice.
In summary, small business loans have potential disadvantages as well as real disadvantages. The differences between potential disadvantages and real disadvantages are their financial actuality such as cost, and credit impact whereas potential disadvantages may include leveraging of a failing business and loss of shareholder confidence and equity.
Small business loans vary in risk that make the riskier loans more potentially disadvantageous than low risk loans. However, even with low risk loans, there may be way to finance business projects and operations in a more effective way. Adequate inventory control, reorganization, internal audits, business strategy adjustment ext. may all contribute to less need for debt and a more profitable and functional business.
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