Figuring out whether you can afford to borrow money for your business is a crucial step in the loan process and one you should definitely take before approaching potential lenders. But determining if you have the resources to make your loan payments can be a bit tricky.
Think Outside The Borrower’s Box
If you want a loan, you’ll need to start thinking about the loan process from the lender’s point of view. So, before you take out your calculator, familiarize yourself with a few key questions. These are the questions lenders have in mind when determining whether you’ll get a loan:
- Can you pay back the loan?
- Will you pay back the loan?
- What are you going to do if you can’t pay back the loan?
If you can answer those three questions, you’re going to find success with small business lenders.
Banks and other lenders use several tools to determine if a business entity is a good candidate for a loan, one of which is a debt service coverage ratio (DSCR). On one side of this ratio is the cash that you, the business owner, have available to pay back a loan in a given year. On the other side is the amount of money you’re borrowing per year, plus interest.
Figuring out your own DSCR isn’t as difficult as some lenders might have you believe. Start by calculating the cash available for your business. Cash available, or cash flow, is the movement of money into and out of your business, measured over a certain period of time — usually weekly, monthly or annually.
To calculate cash flow, start by adding the money that you have on hand at the beginning of the month (starting cash) to the money that comes into your business throughout the month (cash-in). Cash-in includes all the money you receive in sales, paid receivables and interest in a given month. Adding your starting cash to your cash-in will give you your total cash for the month.
Next, you’ll need to calculate how much cash is going out of your business every month (cash-out), including all your expenses for the month. Subtract this number from your total cash for the month to determine the monthly cash flow for your business.
Once you have a number for your monthly cash flow, multiply it by 12 to get your annual cash flow. Then, you can take a deep breath, because the hard part of figuring out your DSCR is over.
The other side is simple – You just do a calculation to determine what the annual debt payments would be on the proposed loan.
Of course, it’s hard to know exactly how much money you’ll end up receiving from a lender or what the terms of the loan will be, but you can make an estimate based on what you know you need to grow your business and the published interest rates for the lending institution you wish to use.
Now that you have both numbers calculated, you can put them side by side and start answering the question you started with: Can you afford a loan?
Business owners with a DSCR of 1.25:1 — also known as 1.25 times coverage — are considered to be a good credit risk, and are usually able to afford, and therefore secure, financing. However, sometimes, businesses that are growing very quickly and those that are expanding to bigger commercial spaces get loans despite having less cash flow.
Figuring out your cash flow is crucial to determining whether you’ll qualify for a loan. However, lenders aren’t just looking at your business’s finances when determining your credibility. More often than not, they’ll also want to know whether you, the business owner, are financially up to par.
Lenders use another tool, called a debt-to-income ratio (DTI) to determine your suitability for a loan. Figuring out your DTI is easy after you’ve already calculated your DSCR. First, tally up your monthly personal debts, including car loans, credit card payments and other debts you might have. Also include your housing expenses, like mortgage payments, property taxes and homeowners insurance.
Divide your total monthly debts by your monthly gross income and then multiply that number (which should be a decimal) by 100 to get a percentage. Most traditional lending institutions look for DTIs no higher than 36 percent.
If, when calculating your DTI, you found that your income far exceeds your debts, you can expect lenders to add some of this excess income to the available cash of your business. This could be a good thing for businesses whose debt service coverage ratios are in need of a boost.
Of course, the question of whether you will pay back a loan can’t be answered by numbers alone. This is why lenders turn to credit scores (FICO scores) in addition to DTIs, DSCRs and the other number-crunching tools of their trade.
Lenders pull FICO scores to determine if the business owner is a good credit risk. Basically do they have a history of paying their bills.
If the prospective borrower’s answer to that question is no, then chances are that he or she isn’t going to get a loan. However, traditional lending institutions — like banks — tend to put more emphasis on credit scores than other, nontraditional lenders. So if you don’t have great credit, you should consider shopping around.
If you can answer, can you pay back your loan, and will you pay it back? — in the affirmative, then you’re well on your way to securing financing. But first, you’ll have to answer one final question: What will you do if you can’t pay back the loan?
This question is certainly not as easy to answer as the other two, because it means admitting a hard truth: You need to have a plan in case your business doesn’t work out.
So What’s The Right Answer?
For some business owners, the right answer is a backup plan in the form of collateral or capital — having assets that the bank can claim if you don’t pay up or extra cash flow that you can redirect toward your loan payments. But for business owners without this cushion, the backup plan takes the form of what lenders call a personal guarantee.
Signing a personal guarantee on a business loan means that, if you can’t pay back the loan through the business, you’ll be required to pay it back out of your own pocket.
But taking personal responsibility for your business debt is a risky move. Therefore, consider the decision carefully before answering this third question.