How to Determine if Your Business Can Afford a New Loan

01 Sep, 2016 / Comments: Comments Off on How to Determine if Your Business Can Afford a New Loan / By

Continually having the capital to keep your business running can be a hard task to accomplish, which sometimes means that you need a new loan to keep things going. Just like a personal loan, your business has to qualify for a business loan. How do you know if you qualify for it? The most important step is determining the affordability of the new loan.

 

What Is Your Debt Service Coverage Ratio?

The most important factor in whether or not you can afford a new business loan is to determine your DSCR or Debt Service Coverage Ratio. If you know this ratio, you know whether or not you can afford a loan, not only under your standards, but under the standards of the bank as well, as this is the ratio they use. To calculate it, you need to know your starting cash amount (the amount in your business bank account right now); the amount of cash you bring in during the month; and the amount of cash you spend during the month. This ending number is your monthly cash flow, and when you multiply it by 12, you get your annual cash flow. You can then divide your intended loan payment by this cash flow amount to see your DSCR. If your DSCR is at least 1.25, you should be able to comfortably afford the loan.

 

Do You Have Collateral?

When thinking of taking out a loan, you will want to keep in mind the worst case scenario if something were to happen to your business. What if you cannot afford the loan down the road? What are you going to do? If you cannot think of any way to pay back the loan, such as selling your collateral, then would you even be able to afford the loan. You always need to have a backup plan or the bank can come after your personal bank accounts and belongings, forcing your personal finances to suffer right alongside your business finances. If you do not have adequate collateral to back you up, then you cannot afford a new business loan.

 

What Is Your Financial History Like?

Your personal financial history might not seem to play a major role in your ability to get business funding, but it does. If you have a poor credit score and a history of not paying your bills on time, this could translate over into your business. If you stop paying your business bills on time, you are going to find yourself in hot water financially. In order to determine if you can afford a new business loan, do not look at the numbers alone, but on your likelihood of paying the loan back on time. If you cannot get your personal finances in order, chances are you should not take on new business debt until you can straighten out your personal finances.

 

Affording a new business loan is not always the only factor to consider; you should also look at your ability to pay back a loan. Even if on paper you can afford what looks like a large business loan, if reality is different regarding your personal habits, it might not be the best idea. Really think it through before you decide to take on a new loan including the trend you see for your business. If this is a new business do you know the cycles your sales will go through? Will you see a slowdown in the near future that could make your loans hard to pay back? These are things to consider before jumping in headfirst into a new business loan that you may think you need right now.

William Mahnic
William Mahnic is a Finance Professor at Case Western University and has spent more than 20 years in the finance industry before becoming a professor. Mahnic has appeared as a commentator on both TV and radio talk shows including NPR, Crain's Cleveland Business, WKYC 3 and The Washington Post. He has been interviewed in BusinessWeek, Wall Street Journal and The Los Angeles Times.

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