Many small businesses borrow money to grow, helping them develop products and services while expanding into new marketplaces. This initial cash injection will really help you get up and running, but it’s also important to think about the ongoing cost of your loan repayments.
These repayments are fees you must repay, just like any other costs in your business—and, as an expense, they directly cut into your profit margins. If you’re operating on thin margins, as many small businesses are, you need to understand the impact of your loan repayments on your profits. Once you know how much your repayments are costing, you can price more effectively and use other financial strategies.
You’ll be able to maintain profit margins without compromising your ability to repay and ensuring you don’t default.
Let’s get into it.
Understanding How Your Small Business Profit Margins Work
Before we get into the impact of loan repayments on your margins, it’s helpful to define what your profit margins are and how you calculate them. We’re going to be digging into numbers and percentages, but hopefully it will all make sense and show why loan repayments are an important consideration.
The profit margin on a particular product or service is the sales price to the customer, less your cost per unit, less a percentage of your overhead costs.
We’ll break this down.
The Customer’s Sales Price
This is the overall charge you make to the customer for selling them your product or service. For the sake of simplicity, we’ll say that this is the “Price Per Unit” whether that unit is a physical item they receive, a digital service, a subscription, a price per hour, or something else.
The Cost Per Unit
This is how much it costs you on a per-unit basis to get your product to the customer. These expenses might include some or all of the following:
- Raw materials and manufacturing to produce an item.
- Shipping and storage costs, both through the supply chain to you, and your costs to send it to the customer.
- Fees and other expenses, like customs fees, third-party marketplace fees, etc, that you pay on a per-item basis.
- Payment processing fees for taking payment via card and some other channels.
- Other costs that are incurred for each item.
In some cases, salaries and other fees you pay may be on a “per-unit” basis, if those costs are directly attributable to providing a specific service that’s charged for.
There are lots of other costs associated with running your business, and they all have an impact on your profit margin, too. These are the expenses that you can’t assign to the sale of one specific unit. In other words, these costs are mostly fixed, and you’ll incur roughly the same overhead costs if you sell 200 units or 300. Examples of overhead costs are:
- Salaries and benefits for your employees.
- Rent and utility costs for your office space.
- Furniture, equipment, and hardware costs.
- Software, sundries, and similar costs.
- Permits, licenses, and professional services.
- Marketing and advertising.
- Insurance and financial services.
- Loan repayments.
To calculate the impact of these costs on your profit margin, you have to add all of them together, and then divide by the number of products you sell. That gives you an effective overhead cost per item. The important thing about overhead costs is that the more you sell, the lower your overhead cost per item.
This Can Be Complicated, Time for an Example
This can all feel quite theoretical and hard to grasp, so let’s break it down with an example. We’ll say that you’re selling green widgets.
Start with Your Basic, Per Unit Selling Price and Cost
- The selling price for each green widget is $30.
- Your per unit cost is $22.
- Before overhead costs, your profit per widget is $8.
Next, Divide Overhead Costs
Your overhead costs per month are $20,000, without loan repayments.
- This means if you’re selling 5,000 widgets per month, your overhead cost per item is $4 ($20,000 / 5,000).
- If you’re selling 10,000 widgets per month, your overhead cost per item is $2 ($20,000 / 10,000).
Finally, Bring Selling Price and Costs Together
So, this means:
- If you sell 5,000 widgets a month, your total profit per widget would be $4, about 13 percent.
- If you sell 10,000 widgets a month, your total profit per widget would be $6, about 20 percent.
How Loan Repayments Eat Into Your Profit Margins
Now, let’s bring it back to loan repayments and how they eat into your profits. If you look at the overhead costs in the previous section, you’ll notice how loan repayments are one of the fees you’ll need to pay. If you’ve borrowed money to build out your infrastructure and grow your business, those repayments can be significant.
For example, if you’ve borrowed $200,000 over a three year term at a 10 percent interest rate, you can expect to repay around $6,500 a month. That $6,500 is an overhead cost that you’ll need to pay with the money you’re making on your widgets.
- If you’re selling 5,000 widgets a month, that’s an extra $1.30 per widget in costs to repay the loan, leaving a profit margin of $2.70, about 9 percent.
- If you’re selling 10,000 widgets a month, that’s an extra $0.65 per widget in costs to repay the loan, leaving a profit margin of $5.35, about 18 percent.
The Impact of Your Loan Repayments
Here’s how a loan of $200,000 at 10% over three years impacts your profits:
- Reduced your profit margin on 5,000 widgets from $4 / 13 percent per item to $2.70 / 9 percent per item.
- Reduced your profit margin on 10,000 widgets from $6 / 20 percent per item to $5.35 / 18 percent per item.
Loans Are Essential to Many Small Businesses, So What Are Your Options?
Loans are a very important source of financing for business growth, and many businesses need loans to fund their expansion. Fortunately, there are a few great ways to reduce the loan’s impact on your profit margins that can balance loan repayments against your need for funding and the profits you make.
Get a Strong Understanding of Your Profit Margins Under Various Scenarios
Your most important starting point is to calculate what your profit margins are likely to be, and then figure out how much you can comfortably put aside for loan repayments. You should figure this for certain sizes and terms of loans, together with your expected number of items sold and revenue.
Reduce Your Costs
We’ve already published some helpful guides that will bring your overhead and other costs down:
- Reduce the Hidden Costs of Running a Small Business
- Great Ideas to Cut Your Small Business Expenses
- Tips on Setting Long-Term Business Finances and Goals
Look at Longer Repayment Terms
You might choose to repay your loan over four or five years, rather than three. Although you’ll end up paying more in interest, it will reduce your monthly repayments, meaning you have a higher profit margin that can find more gradual growth.
Focus on Selling More Products
The great thing about overhead costs, like loan repayments, is that the more products you sell, the less of an individual impact on profit margins. This means you can focus on selling more items in your marketing and advertising. You may need to experiment to find a good balance between price, number of items sold, and profit margins.
Refinance and Consolidate Loans for Better Terms and Interest Rates
Just a small reduction in interest rates can make a big difference in monthly repayments. Once you’ve built up a track record of repayments and have some collateral in your business, it might be worth refinancing with your lenders.
Adjust Your Pricing
Your final option is to adjust your prices upwards to take into account your loan repayments. Obviously this isn’t ideal, as pricing higher may impact your competitiveness. If you do decide to adjust prices, ensure you keep careful track of the impact on sales.
If you need to find the ideal loan for your small business, our loan matching tool gives you plenty of options. It will help you choose a loan with reasonable repayment terms that will help you to keep your profit margins healthy.