As a small business applying for SME business financing, the interest rate is one element of your business loan you should pay extra attention to. Getting approval for SME business financing from a formal lender can be a tricky process. So, it’s easy for you to get swept up in the relief that a lender agreed to lend to you and agree to most of the loan terms the lender proposes.
At CreditEnable, we encourage our customers to strategically think about the loan amount, interest rate, repayment period, and EMI schedule before making the final decision about their SME business financing. Let’s talk about how you can determine what interest rate may work for your small business.
How do I decide what interest rate works for my small business?
When you’re getting SME business financing, you need to think about two things:
- What are my current profit margins, and how will accepting this business financing impact them?
- What will I be using this business financing for?
Based on these answers, you can determine what business loan interest rate will work for your small business.
How do my small business profit margins impact my SME loan interest rate?
You’re running a small business, so while your first goal should be to break even, the second goal should be to start making a profit. As your business grows, you develop a solid customer base, and you can improve, even expand, your business plans based on the things you’ve learned while doing business. Once you break even, your small business should start making a profit, and the profit you make should gradually increase.
Profit margins help you calculate the degree to which your small business is making money. Usually calculated in terms of %, your profit margin tells you how much profit is generated from each ₹ of sale. Your net-profit margin, one of my most significant and commonly used types of profit margin, helps you calculate your small businesses’ bottom line after all your expenses, including taxes, are subtracted from your revenue.
Learn more about Profit Margins.
So, when you’re getting SME business financing, it’s important to consider what your profit margins are right now and how they will be affected by this fresh injection of cash into your business. After getting the loan, your business will have more money to spend, but you will also have to bear the added responsibility of the monthly EMI to pay back, which increases your expenses.
To determine whether it’s worth it getting your business financing at the interest rate the lender proposes, consider whether your net profit margin will increase, decrease, or stay the same after the EMI is factored in.
If it increases or will remain the same, then you’re good to go and may accept the interest rate offered by the lender.
If your net profit margin decreases, ask yourself whether this temporary decrease will bring in more revenue in the long run. If yes, we recommend you accept the interest rate and temporarily work with a tighter profit margin.
However, if the answer is “No”, then start by working backwards. Decide how much you want your net profit margin to be and what interest rate will help you achieve that. Then go back to the lender to negotiate for that rate or something better than what they are offering you that will bring you closer to your desired net profit margin.
Your ability to negotiate with the lender depends on your financial history and credit score, the collateral you offer, and your loan repayment history.
How does my use of the loan impact my decision on the business financing interest rate?
When you apply for SME business financing, we recommend you have a plan. Allocate the money to different activities and project how long it will take you to recover your investment so that you can repay the business loan to the lender.
If you’re applying for a Working Capital loan to introduce new stock to your inventory, consider how the addition will impact your finances. You will have to put up more money to purchase them but will the demand for these products generate enough revenue for you to cover your expenses and turn a net profit?
Since working capital financing is usually used to cover routine business expenses, the timeline for when you’ll make a profit will have an impact on the interest rate your business can afford. Working Capital loans usually do not have long repayment periods, and a short-term loan is accompanied by a higher interest rate.
If you anticipate the investment will show results fast, you can afford a higher interest rate because you know you’ll have more revenue coming in almost immediately and to repay the lender quickly.
Alternatively, if you’re getting a loan to fund expansion plans, the loan may have a longer tenor and a lower interest rate because the impact of your investment will take longer to generating profit. It’ll take you some time to set up your new operations, hire new employees, build a larger client base, and fine-tune your operations before you can break even and then generate profit. So, in this case, it is more advisable to go with a lower interest rate and longer loan tenor, which means your EMI instalments will be smaller in value but you’ll be repaying the lender longer.
How does a lender decide what interest rate to offer me for my SME business financing?
When thinking about the SME loan underwriting process, it also helps understanding how the lender decides what interest rate to offer you.
Lenders consider interest rates in association with the risk associated with lending to your small business. Are you a trustworthy borrower, and does your business have the capacity to generate enough income so that you can finance your daily expenses, pay your EMI instalments, and save some cash for future investments?
Read in detail how lenders make the interest rate decision when lending to small businesses.
Conclusion
When applying for SME business financing, you also need to consider what type of interest rate you should choose – fixed or reducing.
Learn about the two types of interest rates here.
Getting an SME business loan can be daunting since there are many different things for you to consider, but at CreditEnable, we try our best to make the process and decision-making easier for you.
We partner with 25+ leading lenders across India and have helped thousands of SMEs find the right financing loan for their business needs. We can help you too!
We learn about your business, and then our lender-matching algorithms will match you with the right SME loan product that best addresses your business needs now.