This is default featured slide 1 title
This is default featured slide 2 title
 

Can You Afford a Small Business Loan?

Figuring out whether you can afford to borrow money for your business is a crucial step in the loan process and one you should definitely take before approaching potential lenders. But determining if you have the resources to make your loan payments can be a bit tricky.

To demystify the math behind small business loans, Business News Daily spoke with two small business lending experts: Chris Hurn, co-founder and CEO of the small business commercial property financing firm Mercantile Capital Corp., and Ty Kiisel, director of content marketing at Lendio, an online platform that connects small business owners with potential lenders.

Can you?

Banks and other lenders use several tools to determine if a business entity is a good candidate for a loan, one of which is a debt service coverage ratio (DSCR). On one side of this ratio is the cash that you, the business owner, have available to pay back a loan in a given year. On the other side is the amount of money you’re borrowing per year, plus interest.

Figuring out your own DSCR isn’t as difficult as some lenders might have you believe, Hurn said. Start by calculating the cash available for your business. Cash available, or cash flow, is the movement of money into and out of your business, measured over a certain period of time — usually weekly, monthly or annually.

To calculate cash flow, start by adding the money that you have on hand at the beginning of the month (starting cash) to the money that comes into your business throughout the month (cash-in). Cash-in includes all the money you receive in sales, paid receivables and interest in a given month. Adding your starting cash to your cash-in will give you your total cash for the month.

Next, you’ll need to calculate how much cash is going out of your business every month (cash-out), including all your expenses for the month. Subtract this number from your total cash for the month to determine the monthly cash flow for your business.

Once you have a number for your monthly cash flow, multiply it by 12 to get your annual cash flow. Then, you can take a deep breath, because the hard part of figuring out your DSCR is over.

“The other side is simple,” said Hurn. “You just do a calculation to determine what the annual debt payments would be on the proposed loan.”

Of course, it’s hard to know exactly how much money you’ll end up receiving from a lender or what the terms of the loan will be, but you can make an estimate based on what you know you need to grow your business and the published interest rates for the lending institution you wish to use.

Now that you have both numbers calculated, you can put them side by side and start answering the question you started with: Can you afford a loan?

Hurn said that business owners with a DSCR of 1.25:1 — also known as 1.25 times coverage — are considered to be a good credit risk, and are usually able to afford, and therefore secure, financing. Kiisel estimated the optimal cash flow needed for a loan-worthy business a bit lower, at 1.15 times coverage.

But Hurn also noted that, over the years, he’s seen many businesses slip under the 1.25-times coverage threshold. For instance, sometimes, businesses that are growing very quickly and those that are expanding to bigger commercial spaces get loans despite having less cash flow.