Can Your Company Actually Afford a Small Business Loan?

By Carl Faulds

When you're seeking financing, particularly financing to power growth, it’s all too easy to overlook one important question: Can your small business actually afford the borrowing? Here are steps to take to determine whether your small business can afford a loan.

Calculating your debt service coverage ratio

To understand what you can borrow, you first need to know what you can afford to repay. In turn, this will require you to calculate your debt service coverage ratio (DSCR). Put simply, the DSCR is the ratio of cash you have available to service debt (which could mean repaying capital or paying interest and fees).

The calculation can be made in several ways, but we’ll simply discuss the two most common options. One formula is as follows:

(Annual net operating income) – (Depreciation and other non-cash charges )/ Interest + Current maturities of long-term debt

Alternatively:

(Earnings before interest, taxes, depreciation and amortization-EBITA) / (Interest) + (Current maturities of long-term debt)

So for example, if your net operating income is $64,240 and your loan will cost you $51,392 each year, your DSCR would be 1.25 ($64,240 / $51,392). Clearly you need to factor other borrowing into the equation, so if you will be paying $12,848 to another lender then your DSCR is reduced to 1.0.

Should your DSCR fall below 1.0, you will find yourself with a negative cash flow. For instance, a DCSR of 0.9 would mean that you could cover only 90% of your debt repayments and would have to use your personal finances to make up the shortfall. In general, lenders will decline to do business with you in this situation, though there may be some exceptions.

How lenders view your DSCR

Every lender has different criteria when it comes to evaluating your DSCR. Most will play it safe and consider 1.25 the minimum to approve a loan, while others will be more cautious and consider 1.35 the minimum acceptable. Furthermore, these criteria may not be fixed—they may vary across different types of loan and are likely to be reviewed regularly as the economy moves from boom to recession and back again.

RELATED: 10 Key Steps to Getting a Small Business Loan

You should also be prepared for lenders to ask for your DSCR from previous years to give them an idea of trends in your company’s finances, particularly if you’re in a phase of rapid growth.

What’s your debt-to-income ratio?

Another way of evaluating whether you can afford a small business loan is to look at your debt-to-income ratio. This approach, in contrast, considers a loan’s affordability within the broader context of your other debts.

To make the calculation, you should calculate all your personal and business debts—including everything from corporate loans to personal mortgages—then divide the sum by your monthly gross income. Multiply the final figure by 100 and you have a percentage that tells you how much your income exceeds your debts (or falls below it, if your finances are in a poor state).

This is a much less useful calculation to assess your readiness to borrow, but it will give you a broad sense of how you are performing financially. In general, if your debt-to-income ratio is more than 36%, you should think twice about taking on additional borrowing—and be prepared to face rejection if you go ahead.

Introducing loan performance analysis

Finally, if you want to evaluate your financial position from a further perspective, you should consider loan performance analysis. This approach differs from the debt service coverage ratio and the debt-to-income ratio in that it examines both sides of the equation—the financial risks of taking on additional borrowing versus the potential rewards of investing in business growth.

Essentially, you will be attempting to assess how taking out a small business loan will ultimately impact your company’s figures. You will therefore need to consider your current revenue and profitability, and project what can realistically be achieved if you take out the finance. It is important when making this projection to be realistic. If you are overly optimistic, you could find that taking out additional borrowing is far less advantageous than you originally thought.

It is also important to make this calculation in conjunction with that for your debt service coverage ratio. The simple truth is there is no point whatsoever in borrowing to power rapid growth if somewhere along the way you find you cannot service your debts or pay your suppliers.

Remember to consider the full suite of lenders

Finally, it’s important to remember that not all loans are created equal and there are ways of taming a troublesome cash flow that stands between you and success.

Borrowing the same amount of capital from different lenders can result in very different monthly repayments, due to differing interest rates and loan terms. The longer you borrow, the lower your monthly repayments (though the higher the total interest you will have to pay), while secured loans—which can use virtually any business or personal asset as collateral—will generally attract lower interest rates as the lender’s risk is reduced. However, it’s important to remember that if you default on this type of borrowing your lender can easily seize your security, whereas with an unsecured loan they will need a court judgment to get their hands on your assets.

If you hit ongoing cash flow problems along the way, you might want to consider invoice factoring or discounting. These innovative solutions allow you to borrow against the value of your invoices as soon as you issue them, with repayment being made when your customers pay you. With factoring, the finance company takes over your debtor ledger and assigns experienced credit control professionals to secure early payment (thus minimizing the interest you pay), whereas with invoice discounting you retain control of your own debtors so your customers don’t find themselves dealing with a third party.

Whichever financing solution suits your business, you should find that borrowing pays dividends—provided you make certain that you will have no difficulty making payments while continuing to meet your outgoings.

RELATED: 7 Ways to Know It's Time for Your Business to Get a Loan