This is a guest post by Meredith Wood (@mere_wood), head of content and editor-in-chief at Fundera (@fundera), an online marketplace for small business loans that matches business owners with the best funding providers for their business.
There are plenty of reasons to take out a loan for your small business. Maybe an unexpected storm destroyed some inventory and you need help making payroll next month. Or possibly you’re looking into expanding your operations by exporting, opening up a new location, or hiring more workers. No matter the cause, every quest for financing needs to include one simple question:
Can my business afford this small business loan?
Mo’ Money, Mo’ Problems
Well… Maybe. But at any rate, it’s not simply the case that a business that brings in more revenue can necessarily afford bigger, better loans.
It’s true that your revenue can impact what loans you qualify for, alongside other factors like your credit score, the length of time that you’ve been in business, your financials, market trends, and so on. However, the bigger the business, the bigger the loan it needs: your business’s success, rather than its size, will determine what sorts of loans you can afford. A small business with great cash flow management could very well afford a better loan deal than a bigger business without the same financial acumen.
Now that we’ve established the wrong answer to that all-important question, let’s take a look at the right one.
Mo’ Debt Service Coverage Ratio, No Problems
Alright, so it should be “higher debt service coverage ratio,” but you get the idea.
The Debt Service Coverage Ratio, or DSCR for short, is the measure of how available your income is to cover your debt payments. The higher your debt service coverage ratio, the more debt you can take on – and use for emergencies, operations, or business opportunities.
The DSCR is your net operating income divided by your total debt service. In other words, once you find the ratio between your income left over after operating expenses and your monthly loan payments, you’ve got your DSCR. The first half of that equation – your monthly net operating income – takes into account things like your revenue or sales, the costs of your goods sold, and your payroll, rent, utility, and insurance expenses, among other miscellaneous costs. It’s what you make, minus what you need to spend. The second half changes based on how often you make debt payments, and what those payments are. The DSCR is most often expressed as a multiple, and that multiple indicates how much cash you have after expenses to make your debt payments.
Let’s look at a few examples.
- Once you’ve gotten your finances all figured out, you find that you have a DSCR of 1.5. That means you can pay back your debt payments in full, and then half over again, with the cash left over from your operating expenses. That’s pretty great!
- Alternatively, if you’ve got a DSCR of 1, you can just make your debt payments. Typically this isn’t confidence-inducing enough for most lenders: banks and many lenders generally look for DSCRs of 1.25, while more aggressive or conservative lenders might vary down or up from that, respectively. Demanding a higher DSCR is fair to the borrower as well as to the lender because it provides a vital “what if” cushion.
- On the other hand, a DSCR of below 1 means you’re simply not paying your loans – and it’ll be hard to secure another, in that case. A high DSCR, meanwhile, indicates that you’re plenty secure…. But it might be time to look into another loan, because your business is in the perfect place to grow!
Once you understand your DSCR – and from there, how much money you should be looking to borrow – you can use this Loan Affordability Tool to calculate whether a specific loan, with its terms and effective APR, is a good idea for your small business.
We’ve answered “Can my business afford this loan?” in a pretty literal way. These are the formulas and tools you need to figure out, numerically, whether your business’s finances would support a certain loan. But there’s another side to consider.
What if something goes wrong?
Defaulting on a loan can lead to some scary consequences, both short term and for the future of you and your business. Your credit score will suffer, future loan interest rates will hike, and collateral might be seized, to start with. Of the roughly half a million small businesses that falter every year, 33 percent of those that have been around for five years or less fail because of financial causes. Accordingly, you’ll want to do everything you can to ensure that you’re never in a position to renege on a loan.
That means being cautious, even in the most successful of times for your business. Life is an unpredictable adventure – but that’s not always a good thing. Ask yourself: if unforeseeable circumstances might prevent you from paying your loan from the revenue your business makes, do you have other paths to try? Maybe family or friends will step in, or you have strong enough personal finances to withstand a sudden loss, or you can cut costs and liquidate assets to cover the gap. Every smart small-business owner looking for a loan needs to ask this tough question – and unfortunately, there’s no calculator to help you figure out the answer here.
All in all, understanding what loan amount your business can afford can be difficult but rewarding. Once you decide on a range or figure to seek in your loan options, you can start the fun part: planning how to use that cash influx to expand your small business and knock it out of the park.