Should You Take a Business Loan: When It's Justified

A business loan is justified when it finances something that brings extra profit, and that profit covers the payment with room to spare. Then the interest is the price of having the investment work right now, without months of saving up. For a short shortfall, there are usually tools cheaper than a loan: a calendar, a deferral, and a reserve.

Let's go through five conditions under which a loan is justified, and calculate it on the example of a bakery: the payment, the total interest, the payment coverage, and the payback. This is general material and doesn't replace financial advice. Loan terms depend on the bank and the country, and the decision is worth checking with an accountant or financial adviser.

In plain terms. Picture renting a tool that lets you fill more orders. The rental fee is justified if the extra orders bring in more than it costs. A loan for equipment works the same way: the interest is the price of having the tool appear earlier than the funds for it would have piled up.

Five conditions under which a loan is justified

The loan finances something that brings profit

That's equipment that increases output, inventory that turns into sales, or a move into a new line of business. Such investments create extra profit, and the payment comes out of it. Spending that doesn't create profit leaves the payments without a source of their own.

The payment is covered by extra profit with room to spare

The extra gross profit from the investment is divided by the payment. A result above one means there's enough profit for the payment. The room to spare is needed because the return on an investment doesn't arrive right away.

The total interest is smaller than the benefit

The total interest is the sum of interest over the whole term. The benefit is the extra profit over the same period. A loan is justified when the benefit is noticeably larger than the total interest.

There's a reserve for weak months

The payment doesn't depend on the season, while revenue does. A reserve covers the payments in months when revenue is lower. How to calculate such a reserve is covered in the material on business seasonality.

The need is long-term

A loan is designed for a term of several months or more. A short shortfall that will close with the next receipt is cheaper to cover with a calendar, a deferral, or a reserve. A loan is appropriate when the investment pays back within the term.

How to calculate whether a loan is justified

Picture Taras. He runs a small bakery. A new oven costs $12,000 and lets him bake more: extra revenue of $4,000 a month at a 40% gross margin. The bank offers a loan of $12,000 for 12 months at 24% per year. Payments are on a declining balance: the principal part is the same every month, and interest is calculated on the remaining balance.

Interest for a month = Balance × Annual rate ÷ 12

Step one: calculate the payment. The principal part each month: $12,000 ÷ 12 = $1,000. First month's interest: $12,000 × 0.24 ÷ 12 = $240. First payment: $1,000 + $240 = $1,240. In the last month, the balance is $1,000, interest is $1,000 × 0.24 ÷ 12 = $20, and the payment is $1,020.

Step two: calculate the total interest. Interest falls evenly from $240 to $20, so the average is ($240 + $20) ÷ 2 = $130 a month. Over 12 months: $130 × 12 = $1,560. In total, the business will repay $12,000 + $1,560 = $13,560.

Step three: calculate the extra profit. The oven adds gross profit per month of $4,000 × 0.4 = $1,600.

Payment coverage = Extra gross profit ÷ Payment

For the first, largest payment: $1,600 ÷ $1,240 = 1.29. The extra profit covers the payment with almost a third to spare. In meaning, this is close to the debt service coverage ratio that banks use. In the example, we only take the profit from the investment itself. What margin of safety a bank requires depends on the bank.

Payback, months = (Loan amount + Total interest) ÷ Extra gross profit per month

Step four: calculate the payback. ($12,000 + $1,560) ÷ $1,600 = $13,560 ÷ $1,600, which is about 8.5 months. The investment pays back before the loan ends.

Step five: check a more cautious scenario. Suppose the oven delivers a quarter less in the first months: $1,600 × 0.75 = $1,200. Then coverage of the first payment is $1,200 ÷ $1,240 = 0.97, and the payback is $13,560 ÷ $1,200 = 11.3 months.

In the base scenario, the payment is covered with room to spare. In the cautious one, the extra profit falls about $40 short of the first payment (coverage of 0.97), while the payback in both cases fits within the 12 months of the loan. The decision depends on whether Taras has a reserve for the first months, when the return is still lower than calculated.

Why look at both coverage and payback? Coverage answers whether the monthly profit is enough for the payment. Payback answers whether the investment will return within the loan term. Two answers together give a fuller picture than either one alone.

Careful. The calculation is approximate. A bank may calculate interest by the actual number of days, charge an origination fee, and require insurance. These costs increase the total interest, so it's worth adding them to the calculation if they appear in the contract.

What can close a short shortfall without a loan

If a shortfall is visible several weeks ahead and closes with the next receipt, there are four tools that usually cost less than a loan. A payment calendar shows the day of the shortfall in advance. A deferral from a supplier moves the payment to a date after the receipt. A request to a customer to pay earlier brings the receipt closer. A reserve covers the shortfall with your own funds. Each tool is covered in a separate material.

How this looks in your books

In BizFin, a loan is recorded in the “Debts” section on an account of the “Loans (loans, installments)” type. In the record form, a preview of the payment schedule appears under the fields: date, payment amount, principal share, and interest share. Above the table is a summary along the lines of “12 payments · overpayment $430.” It's convenient to fill in the form for two ways of splitting, “Equal parts” and “Declining balance,” and compare the overpayment on the same terms.

Once the loan is set up, in the “Profit and Loss” report, loan payments are shown in a separate list, while interest on debts sits in its own section. The “Debt Service” card shows how much was paid over the period, and that amount isn't included in expenses. That shows which part of a payment is an expense and which is a debt repayment. In the “Balance” report, accounts of the “Loans” type appear among liabilities.

The extra profit from the investment is visible in the “Profit and Loss” report by month after the purchase, while you calculate payment coverage and payback using the formulas from the article.

Careful. The section has limits. The rate is one for the whole term, the schedule is built only when the record is created, late-payment penalties aren't calculated, and reminders aren't sent to your email or phone. The payback of an investment isn't shown in the report as a separate indicator.

What's worth remembering

• A loan finances profit. An investment that creates extra profit gives the payment a source of its own.

• Payment coverage above one. Extra profit divided by the payment shows whether there's enough of it for the payment.

• The total interest is calculated in advance. Interest over the whole term is known before you sign the contract and gets compared with the benefit.

• A cautious scenario is part of the calculation. The return on an investment doesn't arrive right away, and the margin of safety takes that into account.

• A short shortfall has cheaper tools. A calendar, a deferral, and a reserve often close it without a loan.

Frequently asked questions

Should you take a loan for your business?

It depends on the calculation. A loan is justified when it finances an investment with extra profit, and that profit is enough for the payment with room to spare. The decision is worth checking with an accountant or financial adviser.

When is a business loan justified?

When the investment creates extra profit, the payment is covered by it with room to spare, the total interest is smaller than the benefit, there's a reserve for weak months, and the need is long-term.

How do you calculate the total interest on a loan?

Add up all the payments and subtract the loan amount. For declining-balance payments, interest falls evenly, so the total interest equals the average of the first and last month multiplied by the number of months. In the example, that's $130 × 12 = $1,560.

What is payment coverage?

It's the extra gross profit from the investment divided by the payment. A value above one means the profit is enough for the payment. In the example, for the first payment, it equals 1.29.

How do you calculate a loan's payback?

Divide the loan amount plus total interest by the extra gross profit per month. In the example, $13,560 ÷ $1,600 gives about 8.5 months.

What can replace a loan for a short shortfall?

A payment calendar, a deferral from a supplier, a request to a customer to pay earlier, or a reserve. These tools are usually cheaper than a loan if the shortfall closes with the next receipt.