Can You Afford a Small Business Loan? Here's How to Know
When it comes to growing a business, a loan can mean the difference between mild progress and extreme success. There are so many possibilities, whether you’re looking to add to your team, expand into a new territory, or invest in state-of-the-art equipment to improve production.
But taking out a small business loan isn’t always a fiscally-responsible decision. It may seem counterintuitive, but the best time to take out a loan is when you already have money in the bank. You can’t risk taking out a loan that you can’t afford to pay back.
Thankfully, there is plenty of information available to help you decide whether it’s a good time for you to apply for a business loan. You’ll need to put yourself in the lender’s shoes and decide whether you’re a good (read: low-risk) investment. Follow these steps to assess where you stand, and then make that important decision.
Calculate your debt-service coverage ratio
Your debt-service coverage ratio, or DSCR, is one of the most important factors that business lenders consider when you apply for a loan. This is the ratio of cash that a business owner (you) has on hand to pay back a loan over a year-long period in regards to how much they’ll be borrowing (including the interest you’ll have to pay).
To start calculating your DSCR, first consider your cash flow over a given period. For example, start with the money you have at the beginning of a month—starting cash—and add it to the money that will be coming in over the course of a month—cash in. This will be your total cash for the month.
Then, subtract your month’s business expenses—cash out. The number you’re left with will be your monthly cash flow. Multiply it by 12, which will give you your annual cash flow.
Now, in order to determine your DSCR, you will simply need to determine the proposed annual debt payments that will come with your loan. Even if you don’t know the exact amount you’ll receive from a lender, make an educated guess. Take into account the amount you already know you’ll need to borrow to grow your business, as well as your lending institution’s existing interest rates.
The DSCR that’s acceptable will vary from lender to lender, though 1.25 (i.e., 1.25 times coverage) is generally thought to be a good credit risk. However, some lenders will be happy accepting a lower DSCR—maybe even 1.15—while others will require even higher than 1.25.
Accounting for your lending history
Once it's been determined that you will be able to pay back your loan, financially speaking, lenders will try to answer a bigger question: Will you actually pay it back? Your ability to pay back your business loan is certainly an important determining factor, but even with great cash flow, lenders don’t want to work with business owners who have a poor history of debt.
RELATED: The Most Common Reasons Business Owners Are Turned Down for Funding
They will look to your credit score; business owners with poor credit histories are less likely to qualify for a favorable business loan since they are a greater risk. If you have a good history of making all bill payments on time, you should hopefully have the credit score to reflect this.
However, life happens—and so do bad credit scores. Don’t get discouraged if a traditional, conservative lender, like a bank, initially turns you down. If you know you can afford to take out a business loan, do continue checking out your different options, as there are several online lenders offering a variety of small-business financing products.
Knowing when it’s the right time
Of course, taking out a business loan comes with a fair share of “what ifs”—the biggest being, what if something happens and you can’t continue paying back the loan? Many business owners sign a personal guarantee, so if something happens to the business, they will be personally responsible for paying back the loan. Otherwise, you as the business owner will need to have some form of collateral to put up against your loan.
This means that both your business and you personally should be in good financial standing before taking out a small business loan. If you’ve determined that your DSCR is currently too low, which means now is not the right time to take out a business loan, start regularly keeping track of your DSCR. You’ll gain a good overall understanding of your cash flow, so when the right time for a small business loan comes, you’ll know right away.
