factoring companySmall business loans can be a smart choice, particularly if you’re experiencing a seasonal lull or you want to expand your business, purchase equipment or build credit. The problem is, many small business owners start digging into whether they can get approved for a loan before looking at what it will take to pay the balance off. Both are important components. We’ve compiled some tips to show you how to evaluate the affordability of your small business loan, so you’ll have a good idea as to whether you’ll qualify for one and give you a clearer picture of how paying it off will impact your business.

Knowing the Affordability of Your Loan in Advance Matters

Banks look at a number of factors when determining whether to extend a small business loan or not. The ultimate concerns are that you have the ability to keep up with your monthly payments, that you will be able to make them on time, and that you are likely to do so. Your credit score provides insights into your reliability as a payer, but lenders will use your debt service coverage ratio (DSCR) and debt-to-income ratio (DTI) identify if you have the bandwidth to make the payments.

Use Debt Service Coverage Ratio to Determine Affordability

Your debt service coverage ratio can help identify how much your business can safely borrow. Lenders will likely use this calculation to determine your eligibility, but you can run the numbers in advance to gauge your eligibility and ability to repay the loan.

Start by calculating your yearly business income.

Begin by calculating how much your business is expected to earn this year. You will need historical data to prove your projections. Businesses that have not been around long enough to have one or two years of history will generally not get approved for loans. Bear in mind, some lenders will allow you to include personal income from other sources and others will not, so it’s typically better just to focus on the income being earned through the business which needs the loan.

Next, subtract your operating expenses.

From your annual income, subtract all expenses you’ll have this coming year, such as payroll, rent, utilities, and inventory. The number you arrive at is referred to as your “net operating income.”

Example:

Item Amount
Gross Income $250,000
Rent -$18,000
Payroll -$150,000
Inventory, Supplies & Equipment -$50,000
  $32,000 Net Operating Income

Then, tally up your annual debt obligations.

Include all debts your business will pay for the entire year including any interest charges and fees.

Example:

Item Amount
Credit Card $600
Previous Loan $12,000
  $18,000 Debt Obligations

Lastly, use the formula: Net Operating Income / Current Year’s Debt Obligations = DSCR

To calculate your DSCR, divide your net operating income by your current year’s debt obligations.

Example:

32,000 / 18,000 = 1.78

A good DSCR is 1.25 or greater.

In short, if your DSCR is equal to 1.0, that means your business is breaking even. It’s worrisome because any kind of emergency or lull in business will mean you cannot cover your debt obligations. Banks look for at least a 1.25, though some especially cautious lenders may raise the bar to 1.35. If your score is under 1.0, it means you’ve got a negative cash flow. Chances are, you won’t get funded and you should take steps to correct this right away.

In the example above, our business has a DSCR of 1.78, which means lenders will look favorably upon it. However, this amount does not include the burden of taking on a new loan.

Work backwards to find out how much you can afford to borrow.

You can use the numbers you’ve gathered to see how much you can afford to pay each year too. Use the formula Net Operating Income / 1.25 = Maximum Yearly Loan Costs.

Example:

32,000 / 1.25 = 25,600

Under this example, our business can afford to pay a maximum of $25,600 in principal, interest, and fees each year.

Use Debt-to-Income Ratio to Evaluate Personal Affordability

Many small businesses will not qualify for a loan on their own. This is almost always the case when the business is a sole proprietorship or when the individual is a freelancer, but it happens frequently with start-ups and small businesses of all types. In these situations, the business owner’s ability to repay the debt is tabulated using a debt-to-income ratio (DTI). Some lenders will look at both the DSCR and DTI for added assurance.

Start by calculating your personal monthly income.

For the purpose of DTI, you’ll add up income you receive from all sources each month before taxes are taken out.

Example:

For the sake of simplicity, we’ll say our sole proprietor in this example is bringing home $4,000 per month before taxes.

Then, tally up your personal month debt obligations.

Include the minimum payment you’re required to make for each recurring debt you pay on every month.

Example:

Item Amount
Mortgage $1,000
Credit Card $100
Auto Loan $250
Student Loans $100
  $1,450 Total Recurring Monthly Debts

Lastly, use the formula: Monthly Debt Payments / Gross Monthly Income = DTI

To calculate your DTI, divide monthly debt payments by your gross monthly income.

Example:

1,450 / 4,000 = 0.3625 or 36-percent

A good DTI is 36-percent or less.

Most lenders want to see you at a 36-percent or less debt-to-income ratio overall, but they do have stipulations as to how much of your debt can go toward certain things as well. For example, a mortgage payment shouldn’t be responsible for more than 28 to 32-percent of your debt.

Using our prior example, the business owner’s personal debt-to-income ratio sits right at 36-percent. At this stage, lenders will become wary of offering loans. The business owner might still qualify but would have a higher chance of getting approved and getting good terms if the credit card and/ or auto loan were paid off.

Work backwards to find out how much you can afford to borrow.

Just as we did with DSCR, we can work backwards with DTI to find out how much of a loan we can afford. Use the formula Gross Monthly Income x 0.36 = Maximum Monthly Loan Costs.

Example:

4,000 x 0.36 = 1,440

Under this example, your recurring monthly debt payments should not exceed $1,440.

Explore Alternatives if a Small Business Loan Won’t Work

As you can see, it’s quite easy to fall short when it comes time to pay back a small business loan. If you’ve crunched the numbers and realized you either won’t get approved, or it’s too close for comfort, you still have options.

1. Increase income or revenue.

The ultimate goal is to improve your DSCR, so your business qualifies, or improve your DTI, so you qualify. One method of approach is to increase what your business earns or give yourself a raise.

2. Reduce your business or personal debts and expenses.

As we showed in the example, the borrower was right on the cusp of being able to qualify based upon DTI. With any one of the recurring debts paid off, the business owner would likely have been approved. The same methodology can be applied to business expenses, too. Can you cut back on labor, inventory, supplies or rent?

3. Skip taking on debt and use invoice factoring.

Invoice factoring is a way of getting around loans. Instead of borrowing, you sell your B2B invoices to a third party, known as a factoring company. Because this is an outright purchase, there’s nothing to pay back later, and your debt does not increase. However, you get payment for the invoices right away instead of waiting the standard 30, 60, or even 90+ days for customers to pay. The factoring company also collects payments, which means you might be able to cut back on administrative costs associated with invoicing and collections, too. If factoring sounds like a better solution to your business funding needs or can help you bridge the gap until you qualify for a traditional loan, download our free factoring guide to learn more.