When does paying an interest of 3% per month for your business loan make sense?

When it comes to alternative lending, it is often associated with “loan sharking” or even predatory. This is primarily due to the interest that these lending facilities typically comes with, which lies in the range of 2-3% per month. On an annualized basis, you are looking at upwards of 24% p.a. which can sound daunting. Still, the alternative lending is a growing exponentially. Take for example one of the prominent names in the market, Funding Societies. They grew their loan disbursements by more than 40%, disbursing over S$1.21bn in the last 12 months (Q4-22), a highest since their inception. This is despite interest rates on their SME loans going up to 4% per month. 

So, the big question really - Have SME owners gone bonkers? Or does alternative lending add value to businesses. From speaking to business owners to our own analysis, here’s our take on when paying that 3% per month could make sense. 

1. When you have margins of more than 10% with a short cash conversion cycle (CCC) of less than 2 months

This is our top reason why it makes perfect sense for any business to be willing to pay an interest of more than 3% per month on their business loan. As the saying goes “you need money to make money”, and if the banks are not lending, a higher cost of funds is a small fee to pay if you are able to make higher margins. 

This is where business owners simply add their interest cost to their cost of goods sold. To ensure that you have enough buffer, we recommend at least having a net profit margin of 10% with a cash conversion cycle of no more than 2 months. This means that while you pay 3% per month on the capital required, the capital used to purchase goods can return 10% in net profit in less than 2 months. Therefore, broad calculations show that a business can still make 4% in overall net profit from this deal. And if your margins are wider and cash conversion shorter, overall net profit can be much more! 

An industry of choice is obviously F&B with margins typically more than 20% and cash conversion cycles of less than 14 days. Most importantly and this is the huge caveat for the entire segment is that the loan must be used to deliver higher sales in a short time. Things that most immediately qualify are inventory, sales manpower and marketing expenses. Items like renovation and R&D expenses can also produce returns above 10% but are unlikely to yield them in less than 2 months, posing a potential cashflow risk for businesses. 

2. When you have an urgent cash flow requirement in less than a month

If you do not meet the requirements of a high margin and short CCC business. The only other time we recommend you seek alternative funding costing upwards of 2% per month is for urgent cashflow. Businesses often get caught in tight cashflow situations especially when their short-term assets like receivables end up being longer term than expected. And with recurring short-term liabilities due such as their suppliers, loan repayment, salaries and rental, cash can run dry quickly. In such situations, it is easy to let your emotions take over and feel cornered into taking a loan. Here’s 3 questions we recommend asking yourself to help you make that decision better. 

(1) How long does the business need to cover the cashflow gap based on receivables due or are due soon?

a. Depending on your cashflow gap, a 3% interest rate per month could cost an affordable 10-15% in total over a 3–4-month period (inclusive of processing fee).  So if you need anything longer, this might not be sustainable.

(2) Can the business reasonably sustain the loan repayment in the next 3-6 months? 

a. If no, then you might need to reduce your loan amount and seek other forms of financing for it to be sustainable. 

(3) Is your cash runway less than 1 months? 

a. Having a runway of less than 1 months is highly risky as it leaves little room for error and little time for fund raising. We recommend at least having 3 months of runway so that you can seek other forms of financing, restructure your costs, or hasten your collections process. Therefore, getting a loan might give you that additional time to make those changes. Also seeking financing only at the end of your cash balance almost sets it up for disaster. 

At the end of the 3 questions, you should better determine if the benefits of alternative lending outweigh your cost. Alternative financiers can deliver swift approval processes of less than 1 week which is a stark difference from the 1-month timeline of traditional banks. 

3. When you want a flexible repayment  

One final situation when it makes sense to pay 2-3% per month is when you have a flexible form of repayment. This typically occurs when your loan repayment is revenue based. This means that you repay your loan based on a % of your monthly revenue. This concept is not new. You might have watched Shark Tank with the Sharks asking for 20% of their sales until the 200% of the investment amount is repaid. The concept is similar, and we did a full cover of the concept under Revenue based financing. This way your financier might expect you to make your repayment within 12 months on 20% of your monthly revenue and 130% of the loan amount. This way your estimated interest is about 3% per month but that amount could go up and down based on how long you take to repay on 20% of your monthly revenue. 

Many people associate this form of lending to equity investment. This is because the lender takes some risk on you. If you do well, they get their loan back faster and hence get a higher return. If you do not, their returns are reduced, and your cost of borrowing is lower. So, in this case you might pay a higher interest, but you are protected from some risk of your business not performing. For perspective, a 3% per month interest rate for a variant of equity financing is rather affordable. Equity financiers typically ask for returns of upwards of 30-50%.

Responsible borrowing is key

At the end of the day, we believe that businesses haven’t gone that bonkers after all. In the world of alternative financing, it is the accessibility of capital that is truly adding value to the SME community. While traditional banks serve a wider market with general needs, alternative lending provides capital for productive cases as described above and they still makes sense even at an interest rate of 3% per month. What is most important is that you run through the options and borrow responsibly. 

And if you are still unsure? Arrange an appointment with us here and we would be more than happy to weigh the options with you.