For small and medium-sized businesses, taking out a loan can unlock growth—but it can also create new risks if not approached strategically. If you’re exploring financing, knowing what to consider before taking out a small business loan is essential for protecting your company’s financial health and future.
Below are the key financial considerations SMBs should weigh before signing on the dotted line.
1. Understand the Risks
Before taking out a small business loan, assess both lender requirements and internal vulnerabilities. Revenue volatility, seasonality, or economic sensitivity may impact repayment capacity.
Many loans require personal guarantees or cross-collateralization, which put your personal assets at risk. Consider what would happen if cash flow is disrupted—could your business (and you personally) still meet the obligation?
2. Analyze the Repayment Terms
Loan terms can range from 1 to 10 years. Shorter terms mean faster payoff but higher monthly payments. Longer terms ease short-term pressure but increase total interest paid.
Study amortization schedules closely. Look for balloon payments or early repayment penalties. Your repayment plan should match your cash flow cycle, especially if you’re a seasonal business.
3. Test for Affordability
A critical part of what to know before taking out a small business loan is whether your business can realistically afford it. Use the Debt Service Coverage Ratio (DSCR) to measure this—most lenders require a DSCR of 1.25 or higher.
Also, conduct a stress test on your cash flow. Can your business handle the payments even if revenue drops unexpectedly?
4. Compare Interest Rates and Total Cost of Capital
Interest rates vary widely:
- Banks: 6.7%–11.5%
- SBA loans: 10%–15%
- Online lenders: 14%–99%
Fixed rates offer stability; variable rates can rise unexpectedly. Don’t forget to include fees—like origination, servicing, or prepayment penalties—in your total cost calculation.
5. Know the Impact on EBITDA
Loan payments affect EBITDA margins. Taking on too much debt can reduce profitability, lower valuation, and limit future borrowing capacity. Many lenders prefer total debt to stay below 2–3.5x EBITDA.
6. Evaluate Collateral Requirements
Collateral can include receivables, inventory, real estate, or equipment. Lenders often discount the value of these assets when calculating how much to lend.
In asset-light industries, you may be required to sign personal guarantees or blanket liens, increasing your risk exposure.
7. Legal Terms to Watch
Before taking out a small business loan, review these legal considerations:
- Loan agreements should clearly state terms, repayment structure, and default remedies.
- Watch for predatory terms like “confession of judgment” clauses or undisclosed fees.
- Ensure the lender complies with state usury laws and is licensed in your state.
- Verify any personal guarantees or lien rights and confirm electronic signatures are legally binding.
What to know before taking out a small business loan goes far beyond just comparing interest rates. A loan should support your growth—not jeopardize your stability. By carefully reviewing financial health, legal terms, and repayment structures, SMBs can make smarter financing decisions that align with long-term goals.
If you’re considering your financing options and want clarity on your EBITDA, cash flow, or risk exposure—talk to a fractional CFO who understands how to structure debt strategically for growth.
