In many ways, a small business loan search can be broken down into a step-by-step process.
First step, decide that taking on debt is the next move for your business. Whether to relieve the stress of a coming cash crunch during the slow season or to finance a new, exciting business opportunity, your business needs more capital.
The second step—one often skipped over by eager business owners—is one of the most important parts of the business loan application process: figuring out if you can actually afford to take on a business loan.
How can entrepreneurs looking for business funding be sure that they can realistically afford to take on a small business loan—and pay it back in full, on time, plus interest?
Here’s how you can tell if you can afford your small business loan.
Defining What Your Business Can Afford
If you’re just starting the search for business loans, you need to know what kind of monthly payments and interest rate your business will likely be able to pay back before you get into the thick of a loan search.
To get a sense of what you can afford as loan offers come your way, calculate your debt service coverage ratio.
Debt Service Coverage Ratio
The debt service coverage ratio (DSCR) is another financial ratio that small business owners should be paying attention to.
In the context of your business, the DSCR—sometimes just known as the debt coverage ratio—is the ratio of cash a business has available for servicing debt. “Servicing debt” includes making payments on a loan’s principal, interest, and fees.
A DSCR of more than 1 shows a lender—and the business owner—that the business has enough income to pay its debt obligations.
To calculate DSCR, follow one of these two equations:
- Annual Net Operating Income + Depreciation & Other Non-Cash Charges / Interest + Current Maturities of Long-Term Debt
- EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization) / Interest + Current Maturities of Long-Term Debt
These equations might seem daunting and complex. But when it really comes down to it, both these equations are looking at:
Cash flow / Loan Payment = DSCR
The DSCR formula can be calculated on a monthly or annual basis.
To break the steps down, here’s how it works:
Say your business has monthly sales of about $4,000, offset by monthly expenditures of $1,000. That means your business has about $3,000 in monthly cash flow.
Next, look at what your monthly loan payment would be (principal and interest). Say that comes out to $750 per month.
Following the DSCR calculation, your business’s DSCR would be 4, which is healthy! In this case, your DSCR shows that you could afford the proposed loan.
You can do this calculation yourself, or you can use Fundera’s free Debt-Service Coverage Ratio Calculator to break down your DSCR in a more detailed and comprehensive way.
The Ideal DSCR
As a general rule of thumb, you want to have at least a DSCR of greater than 1 before taking on a small business loan.
If your DSCR comes in below 1, you have negative cash flow—meaning you don’t have enough cash on hand to realistically cover your regular loan payments. Breaking it down further, if a business’s DSCR calculates to 0.95, that business can only afford to cover 95% of the debt payment.
But it’s important to know that each lender might calculate DSCR in a different way and that the ideal DSCR varies from lender to lender. Some lenders might only work with borrowers who have at least a 1.5 debt coverage ratio, but some might only require a 1.25 minimum DSCR.
The ideal DSCR will depend on the kind of loan you’re taking on and the current state of the economy. (If things are good, lenders might be willing to extend credit to businesses with lower DSCRs—something like a 1.15 DSCR. But if times are tough, lenders might only be willing to work with borrowers with a much stronger DSCR.)
Also, be prepared for a lender to ask for your business’s DSCR from the past operating years, too—especially if your business is still in a high-growth phase or looking to acquire another business with the loan.
Another way to check to see if you can afford a loan is by looking at your debt-to-income ratio. This financial ratio is usually more relevant to personal loans or mortgages, but it can be helpful to look at in some business scenarios.
A debt-to-income ratio is a similar concept to the DSCR, but it looks into a loan’s affordability based on your debt obligations as a whole. The ratio tallies up your monthly personal and business debts—like student loans, mortgages, car loans, credit card payments, existing business loan payments—and divides that by your monthly gross income.
This calculation, multiplied by 100, gives you a percentage that shows how much your income exceeds (or comes in below) your debts.
While a debt-to-income ratio doesn’t give an exact a way to see if you can afford a business loan, it does give you a sense of whether you and your business are in a good place to take on more debt. Usually if your debt-to-income ratio comes in at above 36%, a lender is unlikely to view you as a suitable loan prospect.
Loan Performance Analysis
One last way to get the absolute full picture of whether you can afford a business loan is to look at a business loan performance analysis.
When you’re looking at the affordability of the loan, you’re essentially looking at how the loan will impact your business’s financials. You want to see if the loan will help you grow your business—and be a valuable return on investment—instead of putting your business in a financially worse-off place.
A business loan performance analysis can give you a sense of just that. Check out Fundera’s free Loan Performance Analysis Template to see where your business will stand after you take on a loan.
This analysis looks at your current revenues, the projected increase of revenues, cost of financing, your net gain or loss, and so on to see what your business will look like after you sign on the dotted line.
With three solid ways to determine if you can afford your business loan, you’re well equipped to know exactly what you’re getting into before taking it on.
Remember, paying back a loan will cut into your cash flow. So if you’re using a loan to solve cash flow problems, make sure that the loan won’t put you worse off.
And on the brighter side of things, if you’re using the loan to grow your business—maybe open up a new location or develop a new product line—you want to be confident that you’ll make some return on investment.
Calculating your DSCR before you take on a loan is a sure way to see what you can afford!
This article was originally published on the Fundera Ledger on January 11, 2016.