The first steps small business owners take after deciding they could use a business loan includes checking their credit score, preparing a business plan and searching for the most reputable lenders in their industry.
Such business owners are so eager to get started that they forget that all of their preparation efforts will be for naught if they can’t afford the small business loan they have in mind. They must know whether or not their business has the cash flow to be able to earn approval from their lender and pay off debt. Figuring this out will also essentially tell you how much funding you should borrow.
But as we have stated in several previous articles, you don’t have to be a math expert to run a successful small business. This is supported by the fact that all you need to do to determine how much debt you can afford to take on is put a few numbers into two surprisingly simple formulas.
Let’s get started:
Lenders assess the risk of small business loans by examining your debt service coverage ratio (DSCR), which shows how much cash a business has available for paying off debt.
Cash flow / Loan Payment = DSCR
Both parts of this ratio can be represented on a monthly or annual basis. In other words, you could use your monthly cash flow and monthly payments or your annual cash flow and how much debt you’d have to pay back in a year’s time. We’ll use monthly numbers for this example.
To begin calculating the first part of your DSCR, add the cash you have on hand at the beginning of the month to the money that comes into your business by the end of the month.
Then, subtract how much money comes out of your business each month from the answer to that first equation. This will reveal your monthly cash flow, a number lenders will look at closely when deciding whether or not to approve your business loan.
Take your monthly cash flow and multiply it by twelve to determine your annual cash flow, or the first part of your DSCR.
The second part of the ratio represents what your monthly loan payment would be. So let’s say your business rakes in $4,000 a month in sales and spends $1,000. Your monthly cash flow would therefore be $3,000.
An ideal term loan for a business with this level of cash flow would feature monthly payments of $750, including principal and interest.
Put these numbers into the ratio and you are left with a DSCR of 4. A DSCR above 1 indicates healthy cash flow, so a DSCR of 4 means you will easily be able to pay off this hypothetical loan while covering business expenses, such as rent, payroll, and day-to-day operations. If your DSCR is below 1, your business has negative cash flow and almost certainly would not be able to sustain itself while making loan payments. Traditional lenders will typically only lend to borrowers with a DSCR of at least 1.5 whereas non-traditional sources have been known to lend to borrowers with a minimum DSCR of 1.25 or 1.15.
Just In Case You’re Still Not 100% Sure
The next formula to use for determining the affordability of your small business loan is your debt-to-income ratio. This ratio will give you a better idea of whether or not your you and your business are financially comfortable enough to handle more debt. The formula therefore incorporates all of your debt, both personal and business, to see how much your income exceeds your debt, if at all.
Begin by adding your monthly personal debts (credit card payments, student loans, etc) and business debts (any existing loan payments). Then, divide the total by your monthly gross income and multiply the answer by 100 to reveal a percentage. According to Fundera, a debt-to-income ratio above 36% decreases your likelihood of being approved for a loan from a traditional lender.
Your Answer Can Be Adjusted
It’s important to note that the requirements listed in the two previous sections were based off the standards utilized by banks. Alternative business financing companies, on the other hand, are much more accepting of business owners who have low credit scores, which is often a byproduct of outstanding debt. The funding experts at United Capital Source have provided bad credit business loans to many business owners only to see them pay off the debt on time and without trouble, despite occasional dips in revenue. These businesses were offered programs tailored specifically for their situations. There are numerous other UCS funding programs featuring flexible terms designed to accommodate the unique circumstances of the borrower’s industry. We have years of experience working with borrowers in dozens of industries and are well-aware of the ups-and-downs business owners face throughout a given year.
So if you aren’t sure if you can afford the small business loan you need, please do not hesitate to chat with someone from UCS who has dealt with countless business owners in your exact situation. Your eligibility will be assessed not only by your credit score but by the performance of your business. As long you can provide bank statements to indicate a steady stream of revenue, there is a high chance we will find an additional funding arrangement that is right for you!