Define What You Can Afford
One of the first questions lenders will ask you when you start your small business loan search is “How much are you looking for?” Yes, we would all love a cool $5 million. But instead of thinking of this question as how much you want or need, think along the lines of what you can actually afford. If you don’t know the answer to that question, follow the steps below.
Calculate Your Debt Service Coverage Ratio
The best way to determine the small business loan payments your business can afford is to calculate your debt service coverage ratio. This is the number lenders will use to see how much cash you have to service your debt. This is also a number YOU can use to make sure you are comfortable with any potential debt payment. Your debt service coverage ratio is simply:
Cash Flow / Loan Payment = DSCR
You can calculate this on a monthly or annual basis. Here’s how it works.
On average, how much cash flow (sales - expenditures) do you have coming into your business each month? Let’s say it’s $3,000. And how much do you project your monthly loan payment will be (both principal and interest)? Let’s say $1,000. This means you would have a debt service coverage ratio of 3, which is healthy!
All lenders are going to want to see that you have a DSCR of at least 1, because if you don’t, where are you getting the cash to pay them back? However, most lenders will require that you have a DSCR of at least 1.5 or greater. But, don’t forget, you should use this ratio for yourself too! What number are you comfortable with? Decide now. Let’s say it’s 2. Now, take your current monthly cash flow, divide it by 2, and use that number as you shop. Aim to find a loan that will allow your total monthly loan payment to be equivalent to that amount. Want to calculate what your DSCR would be with various small business loan amounts and interest?
Perform a Small Business Loan Performance Analysis
It is important to remember that the reason you are taking out a small business loan is to invest in your business. Before taking on the debt, you need to make sure that you will in fact have a return on this investment. Can you safely say that this debt will grow your business? It’s not an easy question to answer, so a great thing to do before committing to a loan is forecasting loan performance. By running a loan performance analysis, you can see how this small business loan will financially impact your business. It is also a great way to ensure you aren’t taking out too large (or too small!) of a loan.
Step 3 :
Write Down Your Ideal Loan Payment
Now that you’ve taken a look at how small business loans can financially impact your business, and how to calculate your debt coverage ratio, decide on a rough estimate of a total monthly loan payment you’d be comfortable with. Keep this number close as you start your search.