“Can I afford a small business loan?”
For many business owners, this is (literally) the $64,000 question!
With so many variables in play, it may seem daunting to calculate whether you can actually cover new loan payments. Luckily, there are multiple financial ratios in place to help you do just that.
In this post, we’ll teach you how to use the debt service coverage ratio and the debt-to-income ratio to determine whether you can afford a loan, what borrowing amount is right for you, what monthly payment you can afford, and if a loan is actually the rightÂ choice for your business. (If it turns out, based on these ratios, that you can’t afford a business loan just yet, we’ll also give you six practical tips to better your financial situation.)
Read on to see if your small business is ready for financing.
Is A Small Business Loan Right For Me?
This is the very first question you should ask yourself. Just because you can afford a loan doesn’t mean you should take one out. Before you start seeking funding, take the time to really consider your business’s financial situation.
Ask yourself what problems you would be solving by taking out a business loan and consider whether there is another way to solve those problems.
For example, if you’re looking for start-up funding, have you considered venture capital? Angel investors? Crowdfunding? If you’re having trouble maintaining consistent cash flow, have you carefully analyzed your operating costs or cut back unnecessary business expenses to increase revenue?
Make sure to explore all of your optionsÂ before jumping the gun on your loan search. Now, that being said, there are plenty of solidÂ reasons to get a business loan:
- To expand your business
- To purchase inventory
- To buy equipment
- To cover off-season expenses
- To take on a new, high-potential project
- To build business credit
When determining whether a small business loan is right for you, carefully meditate on your business’sÂ short-term and long-term goals. If you haven’t already,Â make a business plan to help you achieve your future goals.
If a loan fits into this plan and benefits your business, great!
Next, we’ll talk about how to know if you can actually afford a loan, how much you can borrow, and what to change if you can’t afford a loan.
What Do Small Business Lenders Look For?
At the most basic level, lenders want to see that:
- Your business has enough cash flow to afford monthly payments.
- You can make those payments on time.
There are many factors that lenders consider when analyzing a loan application, but some of the most important variables are your credit score, your debt service coverage ratio, your debt-to-income ratio, and your ability to put upÂ collateral.
We’ll cover all of these factors in greater detail below.
Using The Debt Service Coverage Ratio
The debt service coverage ratio is one of the main tools lenders use to determine whether you are eligible for a loan — it’s also one of the most important calculations small business owners can do before taking on new debt.
The debt service coverage ratio (DSCR) measures the relationship between your business’s income and its debt. Lenders use this ratio to gauge the risk of lending to you and to see if you can afford to make payments on a loan, given your business’s cash flow.
How To Calculate The Debt Service Coverage Ratio
Each lender calculates the debt service coverage ratio differently. Some lump the business owners’ personal income in with the net operating income; others don’t. We’ll cover the most common DSCR formula, but be sure to ask your lender how they calculate DSCR for the most accurate ratio.
Most often, your business’s DSCR is calculated by dividing your net operating income by your current year’s debt obligations:
Net Operating Income / Current Year’s Debt Obligations = Debt Service Coverage Ratio
Your net operating income is the total revenue generated by selling services or goods, minus your operating expenses (operating expenses include things like inventory, employee wages, rent, utilities — anything that is directly related to purchasing, creating, or selling your goods and products).
Your current year’s debt obligations comprise the total amount of debt you must repay in the next year, including interest payments and fees.
Let’s look at an example:
A business owner wants to know whether or not they can afford a loan to purchase some new equipment. The business takes in $65,000 in revenue annually but pays $15,000 in operating expenses, resulting in a net operating income of $50,000.
Each month, the business spends $2,000 on its mortgage, $400 on a previous loan, and $100 on aÂ business credit card, making a total monthly debt of $2,500. Since the DSCR calculation requires the current yearâs debt, we need to multiply our monthly debt by 12. That gives us a total of $30,000 in debt obligations for the year. Now, letâs plug these numbers into the DSCR formula from earlier.
Net Operating Income / Current Year’s Debt Obligations = Debt Service Coverage Ratio
50,000 / 30,000 = Debt Service Coverage Ratio
50,000 / 30,000 = 1.666667
When you divide 50,000 by 30,000 you get 1.666667. Round this number to the nearest hundredth to get a current debt service coverage ratio of 1.67.
We’ve successfully calculated a debt service coverage ratio! Plug in your business’s information to determine your own DSCR.
What Is The Ideal DSCR?
How do we know what a good DSCR is? What does the DSCR mean in terms of your business?
When it comes to DSCR, the higher the better.Â Letâs say your DSCR is 1.67, like in our earlier example; that means you have 67% more income than you need to cover your current debts. A DSCR ratio of 1 would indicate that you have exactly enough income to pay your debts but arenât making any extra profit. If your DSCR is below one, then you have a negative cash flow and can only partially cover your debts.
Obviously, you donât want a negative cash flow, and breaking even doesnât quite cut it if you want to take out a loan. So whatâs the ideal debt service coverage ratio?
In general, a good debt service coverage ratio is 1.25 or higher. This can vary by lender and by the state of the economy, but overall, a high DSCR suggests that you have enough income to take on another loan and are more likely to qualify for the loan you want.
How Much Can I Borrow?
Not only can your DSCR tell you if you can afford a loan, it can also help you determine the size of the loan you should take out.
Let’s take a look at our earlier example again. We calculated the business’s DSCR at 1.67. This is well above the 1.25 DSCR mark, yes, but it doesnât necessarily tell you theÂ sizeÂ of loan the business can afford to borrow.
To figure out the amount the business can safely borrow, we’ll take its annual income and divide it by 1.25:
Net Operating Income / 1.25 = Borrowing Amount
50,000 / 1.25 = 40,000
From the calculation above, we can see that the business can afford to pay up to $40,000 a year on total debt obligations. In our example, the current yearâs debt obligations were already $30,000/year. All in all, the business can take on an extra $10,000/year in debt (because $40,000 â $30,000 = $10,000). That amounts to roughly $830/mo.
Plug your own information into the equation so you can determine the ideal borrowing size for your small business loan. This will give you a clear idea of how much you can realistically afford to pay each month before you go and speak to a lender.
To learn more about the debt service coverage ratio, read our post Debt Service Coverage Ratio: How To Calculate And Improve DSCR.
Using The Debt-To-Income Ratio
Lenders also use your personal debt-to-income ratio to evaluate whether or not your business is eligible for a loan. The debt-to-income ratio is used primarily for personal loans (especially mortgages), but this ratio is still important for small businesses, especially sole proprietors.
The debt-to-income (DTI) ratio is a financial tool used to measure the relationship between a person’s debt and income.
Why Is DTI Important?
Your DTI is an important indicator of your trustworthiness. Whereas your credit scoreÂ shows how likely you are to make your payments on time, your debt-to-income ratio shows lenders if you can afford the monthly payments on a personal loan or mortgage.
But if the debt-to-income ratio is predominantly for personal loans and mortgages, why is it important for small businesses?
For sole proprietors and freelancers seeking funding, this ratio is particularly important. Since sole proprietors aren’t legally considered separate business entities, they don’t have a debt service coverage ratio. Instead, the debt-to-income ratio is the main tool lenders will use to analyze a loan application.
While the debt service coverage ratio is by far a better indicator of small business’s financial state, lenders still look at the business owner’s DTI ratio. Lenders evaluate your DTI to see if you are trustworthy and to ensure that you can personally guarantee your business loan if no other collateral is provided.
When deciding whether your business can afford a small business loan, make sure you also consider if you can afford to personally take on the business loan payments if your business goes under. No one wants to think about the fact that their business may fail or that they might default on a business loan. But this scary reality is one you must consider before accepting a business loan. If you can’t afford to offer up collateral or take on the implications of a personal guarantee, then maybe a business loan isn’t right for you.
How To Calculate The Debt-To-Income Ratio
To calculate your debt-to-income ratio, divide your total recurring monthly debt by your gross monthly income:
Total Monthly Debt / Gross Monthly Income = Debt-To-Income Ratio
Your total monthly debt should include allÂ recurring minimum monthly debt payments, while your gross monthly income should include your total monthly income before taxes.
Let’s do an example:
Youâre trying to use your DTI to see if you qualify for a mortgage. You pay $300/mo for your car and $200 on student loans for a total monthly debt of $500. Your monthly gross income is $3,500/mo.
500 / 3,500 = Debt-To-Income Ratio
500 / 3,500 = 0.142857
When you divide 500 by 3,500, youâre left with 0.142857. To turn this decimal into a percentage, simply move the decimal point two places to the right and round to the nearest tenth. This gives you a current debt-to-income ratio of 14%. Easy!
Add your own financial information into the formula to see what your debt-to-income ratio is.
What Is The Ideal DTI Ratio?
Now that you know how to calculate your DTI ratio, what does that percentage mean? How do you know if you have a good DTI ratio or a poor ratio?
Unlike DSCR, when it comes to debt-to-income ratios, the lower the better.Â A low DTI indicates that you can afford to take on an additional loan and are more likely to get approved for the loan you want. A high DTI ratio means that you may have too much existing debt or too little income to be able to afford monthly payments on a new loan.
Generally, a DTI ratio of 36% or lower is considered a good debt-to-income ratio. Many lenders will finance (up to) 43%, but if your DTI is higher than 43%, you may have a hard time getting approved for a loan.
However, these percentages may vary by lender. Real estate and mortgage lenders are known to stick more closely to these guidelines, while other lenders may be more lenient. So be sure to research your lender’s requirements.
What Monthly Payment Can I Afford?
You can use the debt-to-income ratio to determine how much you can afford to pay each month on a loan.
This calculation is most important for sole proprietors seeking funding and individuals seeking mortgages. However, small businesses should still do this calculation to make sure that they can personally afford to cover the payments on a defaulted loan.
Letâs return to our example from earlier. Remember, you were trying to qualify for a mortgage loan. We calculated your current debt-to-income ratio at 14%.
To maintain a good debt-to-income ratio, you donât want your total DTI ratio to exceed 36%. That means a potential mortgage can take up 22% of your total debt-to-income ratio (36 â 14 = 22).
In this example, to determine the size of the mortgage loan payment you could afford each month, simply multiply your gross monthly income by 22%. (To convert the percentage to a decimal, move the decimal point two spaces to the left.)
3,500 x .22 = 770
Assuming you still want to stick to a 36% DTI, you can afford to pay $770/mo on your mortgage while continuing to make your other monthly loan payments and covering everyday expenses.
To learn more about DTI, read our complete post: Debt-To-Income Ratio: How To Calculate And Lower DTI.
Consider Your Return On Investment
Finally, when determining whether your business can afford a business loan, you want to make sure the benefits ultimately outweigh the costs.
If you are spending the time, money, and effort on a loan, it’s important to have a good return on investment (ROI).Â Able Lending puts it this way:
The reasonable expected return on your investment must be greater than the APR.
In other words, a loan is only worthwhile if it ultimately helps your business’s profits exceed the costs of the loan, plus interest and fees. Before you borrow money, make sure you have a clear business plan and know exactly how you intend to use your loan to improve your business.
What If I Can’t Afford A Loan?
If you’ve made it to the end of this post and realized that you can’t afford a loan, don’t worry. It’s not the end of the world. There are plenty of ways to improve your business’s financial position so that you can afford a loan in the future.
1. Increase Revenue
Increasing your income can open the doors to more business opportunities and additional funding. By increasing revenue, you can improve your DSCR, lower your DTI ratio, and boost your chances of qualifying for a loan.
2. Decrease Existing Debt
Another way to increase DSCR and lower DTI is to pay off some existing debt. With old loans out of the way, you can move on and take out new loans to help propel your business forward.
3. Improve Your DSCR
We already mentioned that increasing your revenue and decreasing your existing debt can help improve your DSCR. Another way to improve your debt service coverage ratio is to decrease operating expenses. By cutting back on unnecessary expenses and streamlining your business processes, you’ll have a greater overall net operating income — which means more money that you could apply towards a loan.
4. Lower Your DTI
We also already mentioned that increasing your revenue and lowering your debt improves your debt-to-income ratio as well. For borrowers seeking a mortgage, making a bigger down payment is another good way to lower your DTI and decrease the size of your monthly payments.
5. Improve Your Credit Score
Another major roadblock businesses and individuals run into when seeking funding is a low credit score. Improving your credit score can help unlock better loans and rates. To learn more, read theÂ Ultimate Guide To Improving Your Business Credit Score or our article onÂ 5 Ways To Improve Your Personal Credit Score.
6. Lower Your Borrowing Amount
Maybe you really can afford a loan right now and just need to lower your borrowing amount.Â You may not be able to afford the $100,000 loan you were hoping for, but can you afford the monthly payments on a $50,000 loan? If you can satisfy your needs with a smaller borrowing amount, you should try to do so; if a smaller amount won’t meet the brief, use the first 5 tips above to improve your financial situation so you can afford the loan you want.
When wondering whether you can afford a small business loan, you should ask yourself:
- Do I have a debt service coverage ratio of 1.25 or higher?
- Do I have a debt-to-income ratio of 36% or lower?
- Do I have collateral or can I confidently sign a personal guarantee?
- Will the loan lead to a good return on investment?
If you’ve answered yes to all of these questions, odds are your business is in a healthy financial spot to take on a new small business loan. Use the debt service coverage ratio and debt-to-income ratio to discover exactly how big of a loan you can afford.
Wondering what type of small business loan you should take out? Not all loans are created equal, and a bank loan will be worlds apart from an atypical online lending product. Traditional term loans, short-term loans, SBA loans, and merchant cash advancesÂ all have very different rates, fees, and terms. Make sure you understand the differences between different types of funding before you jump the gun on any loan product. Our small business loan calculators can help.
Looking for good lending options? Our small business loan reviews cover online lenders and major banks that offer various types of loans (bank loans, SBA loan, short-term loans, installment loans, lines of credit and more). If you’re just starting out, you might want to consider taking out a personal loan and using it for your business.
To evaluate multiple low-interest lenders at once, itâs a good idea to use a free loan matchmaking service, often called a âloan aggregator.â Merchant MaverickÂ has partnered with Mirador Finance, a financial technology company, to bring you theÂ Merchant Maverick Community of Lenders. By filling out one application, you can be matched to multiple potential lenders. Check your eligibility below.
â¢ Free loan aggregation service; requirements vary by area and lender.
|Check your eligibility
Learn more about the Community of Lenders
If can’t afford a loan yet, you should focus on increasing your ability to afford a loan and your chances of getting approved by a lender. Download our free Beginner’s Guide To Small Business Loans for more information, or consult any one of the following articles:
Debt Service Coverage Ratio: How To Calculate And Improve DSCR
Debt-To-Income Ratio: How To Calculate And Lower DTI
The Ultimate Guide To Improving Your Business Credit Score
5 Ways To Improve Your Personal Credit Score
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