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When to Take Out a Loan for Your Profitable Small Business

Jan. 28, 2015
Small Business
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Everything may be going well for your small business — sales are strong, margins are high and customers keep coming back. But even profitable businesses can benefit from taking out a loan, whether it’s to expand operations and make even more money, gain access to funds in case of an emergency or help manage a future seasonal slowdown.

Here are three reasons a profitable small business might want to take out a business loan.

1. To expand operations

Taking on a small-business loan to expand an already profitable business can be smart. Whether the money is used to purchase new equipment, inventory, real estate or machinery, these are all moves that can boost sales and profits.

For example, a restaurant franchise owner who already operates two profitable locations may see an opportunity to add a third store and increase sales or profits by 50%. Or a pizzeria owner might have an opportunity to purchase new equipment and expand the size of his restaurant, which will boost production and sales. If the growth in sales and profits is expected to outweigh the costs of the loan, it’s likely a wise business move.

In either of the above cases, a bank loan could make the most sense. These loans are geared toward established, profitable businesses, and they come with some of the lowest interest rates of all types of financing. And since you know how much money you’ll need to expand, a bank loan provides you with a lump sum of cash to pay for these costs. You then repay the loan in fixed monthly installments, but the increase in your sales and profits should help you easily service this new debt.

2. To protect against business slowdowns

The U.S. economy lost more than 200,000 small businesses during the recession of 2008, according to U.S. Census Bureau figures. Whether a business took out a credit line before the recession struck could have meant the difference between going under or staying afloat.

So even if your company is profitable, it may be a wise idea to take out a business line of credit to ensure your business can withstand potential market downturns. Applying for a line of credit now, instead of when you really need the cash, guarantees you’ll have money available in a crisis.

In this case, a line of credit is better than a regular loan because you’ll have access to a certain amount of cash, but you won’t be required to use any of it. For example, a $20,000 credit line means you’ll be able to borrow up to $20,000, but you only repay what you actually draw down on the line, and you only get charged interest on what you use.

You can then keep reusing and repaying the credit line as you wish. A bank loan, on the other hand, leaves you with a lump sum of cash that must be repaid monthly, beginning immediately after the loan closes — so it’s far less flexible.

Small-business credit cards are another potential option. These work just like a line of credit in that you get the same borrowing flexibility — access to a certain amount of credit, but no obligation to actually borrow. Some cards even offer cash back and rewards for your spending, sign-up bonuses and zero-interest introductory periods during which you’ll pay no interest on your balance for a specific time. If paid off on time and used properly, these cards can also help improve your personal and business credit score.

The downside: Credit cards tend to come with higher interest rates than other loans, so it’s important to keep a low balance on the card, especially after the zero-interest introductory period ends.

3. For seasonal businesses

A line of credit can also make sense for seasonal businesses that need help managing business cycle fluctuations. Examples include retail businesses that have peak sales during the holiday season, restaurants and hotels at beach towns where things slow down after the summer and snow removal businesses that are dead during summer months.

These types of seasonal businesses need to make sure they have enough working capital during slow times of the year, when sales are much softer. A line of credit could help them bridge this cash flow gap and operate smoothly during months where there may be very little money coming in.

If you operate a seasonal business and need help managing cash flow, you’ll likely want to look for a short-term financing option. Your best bet is either to open a line of credit or get a business credit card, since during the slow months you’ll likely need access to capital, instead of a specific amount of money upfront.

For more information about how to start and run a business, visit NerdWallet’s Small Business Guide. For free, personalized answers to questions about starting and financing your business, visit the Small Business section of NerdWallet’s Ask an Advisor page.

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