The answer depends on a single comparison. Credit is helpful when what you buy with it returns more than it costs you in credit. Credit is harmful when it's used to cover ongoing losses, because the installment is added to the loss. This page gives you the reasoning, not a ready-made answer, because every case has its own figures.
Pose the loan against what it finances. If you use the loan to buy a device, a work vehicle, or a circulating commodity, the question is measurable. How much additional margin does this purchase generate per year, and how much does the loan cost per year, including interest and fees? When the return on what you buy is significantly higher than the cost of the loan, the loan works for you. This is the healthy use of debt.
It's a whole different story with a loan that covers losses. When the cash register stays empty every month because the business sells below cost or spends more than it brings in, a loan doesn't solve the problem. It just postpones it and makes it worse. After a few months the old problem is still there, plus a new installment. In that case the first thing to address is margin and expenses, not the bank. Keith Cunningham puts it simply in The Road Less Stupid. A problem covered with new money isn't solved, it's only made more expensive.
Even a good loan has a characteristic that must be respected. The installment is paid every month, even when sales fluctuate. The bar-restaurant has a strong August and a weak November. The construction firm has months with cash inflows and months with cash outflows. The installment doesn't recognize either. Therefore, before taking out a loan, look at cash flow month by month, not the annual average. That's the right question. Can my weakest month pay the installment, not my average month. Daniel Kahneman reminds us that plans are built on an optimistic scenario. The real monthly cash flow is the antidote to that optimism.
A bakery is considering purchasing a new oven priced at 1,200,000 LEK, financed with a three-year loan. For illustration, let's assume a monthly installment of 40,000 LEK. You should always obtain the actual terms from your bank; they vary depending on the market and the specific case.
The new oven increases production and is expected to bring an additional 60,000 LEK in contribution margin per month. On paper, 20,000 LEK per month remains above the installment. Now for the weak month test. In slow months the additional margin falls to 45,000 LEK. Even then the installment is covered and 5,000 LEK remain. The loan passes the test, narrowly but stably, and the owner knows that in weak months there's no room for further surprises. The same oven with a 55,000 LEK installment would not pass the test, because the weak month would result in a loss. This reasoning is general information about the method, not a recommendation for any specific loan.
At the Resource Center you'll find a worksheet with three rows: the extra margin generated by the purchase, the full monthly installment, and the result in the weakest month. Three rows are enough to see whether it's worth opening a conversation with the bank.
The standard indicator is the debt service coverage ratio, net operating income divided by annual debt service, where banks typically require it to be above 1.2. For a small business, it's more valuable to calculate it based on the weakest month of the year, not the average, because a liquidity crunch happens in months, not years. Always compare the effective interest rate, including fees, not the nominal rate. And verify the collateral structure and prepayment penalties before signing. The effect of financial leverage on return on equity is positive only as long as the return on assets exceeds the cost of debt.
It depends on how much the wait costs. If the device generates more per year than the loan costs, the wait has opportunity costs. If the return is uncertain, saving is the safer route. The calculation is done with your own figures, not with a general rule.
Usually not, because after a few months the installment is added to the loss. The first step is to identify the source of the loss—whether in the margin or in expenses. We often conduct this analysis with our clients, and it becomes clear within a few hours of work.
The decision on the loan is yours and your bank's. If you'd like to review your figures at your leisure before that conversation, we're here. Write to us at Contact page or get acquainted with the packages at offer.
We take care of accounting and taxes, so you can save time, money, and focus on growing your business.
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