how to determine if you can afford the small business loan you need
Many small businesses are looking to get small business loans to finance their operations. But most of them only know that they require checking their credit score and preparing a business plan. They don’t know if they can afford the amount of loan they are looking to get. Here is how to go about it.
DSCR: Cash Flow
Before you can acquire a loan, lenders will assess your risk by looking at your debt service coverage ratio (DSCR). The DSCR reveals the amount of cash available in a business to clear debts. Primarily, the DSCR ratio= cash flow/loan payment. The two parts of this ratio can be represented on an annual or a monthly basis. This means that you can use your monthly/yearly loan payments and monthly/yearly cash flows to get the ratio. To get the cash flow of the business, you need to add the cash at hand at the month’s beginning to the cash made by the business during that month. Then you need to minus the amount of money that goes out of the company every month. This will show the monthly cash flow, which is a figure that lenders will want to see before approving a small business loan. You can multiply this figure by 12 to get the annual cash flow.
DSCR: Loan Payment
The ratio’s second part symbolizes the amount you will repay back to the lender. Hence, in case your small company makes $5,000 per month in revenue and incurs a cost of $2,000, the monthly cash flow would be $3,000. A suitable term loan to be issued to a business that makes this amount of cash flow would include monthly payments of $750 that includes principal and interest. Therefore, the DSCR IS 4. When this ratio is more than 1, it signals that the cash flows are healthy. Hence, a DSCR of 4 indicates that the business will have the capacity to cover the loan payments while paying off business costs, like payroll, rent, and more. In case you have a DSCR of below 1, your company has negative cash flow, and it is highly likely that you will not be able to sustain your business while you clear the loan. Traditional lenders usually lend to companies that have a DSCR of 1.5 or more. Contemporary lenders lend to borrowers who have a DSCR of at least 1.15 or 1.25.
You can also use the debt-to-income ratio to determine if you can afford a small business loan. This ratio will let you know if your business and you, have the financial capacity to handle more debt. Hence, the formula includes all the current debt, both business and personal, to determine how much your debt is exceeded by your income, if at all. Start by adding your monthly business debts and personal debts, like student loans and credit card payments. Then divide the resulting figure by your monthly gross income before multiplying the answer by 100 to obtain a percentage. Fundera states that when the debt-to-income ratio supersedes 36 percent, you have a less likelihood of getting a loan.
It is crucial to note that the debt-to-income ratio and the debt service coverage ratio, are based on bank standards. Alternative financial institutions are more accommodating to entrepreneurs who possess low credit scores, which is usually a consequence of outstanding loans. These financial institutions are offering bad credit loans that end up being repaid on time and with no problems, in spite of a frequent decline in revenue. Many loan programs are customized to businesses that face these challenges. Hence, if you are unsure of your capacity to afford a small business loan that you desire, then go for financial institutions that offer bad credit loans. These lenders will not only use your credit score to determine your eligibility, but they will also use your business performance. In spite of a bad credit score, a bank statement that reveals a healthy cash flow will guarantee you funding.
The DSCR and the debt-to-income ratio are simple formulas that can help any business owner to know the amount of debt they can get. They can, therefore, approach a lender and get the loan they are looking to get without being turned down.