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calculating business loan payments

Can you make your Payments on a Business Loan?

You know that you need a business loan, but can you afford one? Small business owners take out loans for a variety of reasons, from wanting to expand to needing help managing cash flow.

Sometimes the reason is urgent, and without the capital your business could collapse. Other times, it is simply meant to help you grow to the next level. Whatever your reasons, you should never borrow money without knowing that you can afford to repay the loan. It is also important to learn ways to manage your business loan payments as well as learning tips to pay off your business loan faster.

Before signing the paperwork, double-check that all of the numbers work for your business. You can do this by thinking like a loan underwriter.

What is Loan Underwriting?

The underwriting process is when the lender dives deeper into your financials to determine if you can afford the loan. While they collect some preliminary information online or over the phone, during underwriting everything is verified.

The underwriter may check bank account balances and calculate average revenues, as well as examine financial statements and verify credit card receipts. They will pull your credit report and check your credit utilization ratio. And they’re likely to calculate your debt service coverage ratio.

When you apply for a business loan with bad credit or another form of credit with an alternative lender, they often rely upon ratios to make lending decisions. This is because one of the perks of these lenders is their quick approval process. They do not spend months making a decision so ratios become extremely important to them.

Since everything a loan underwriter does is designed to help them determine your credit-worthiness, performing some of these same checks yourself will help you figure out if you can afford a business loan.

What is a Credit Utilization Ratio?

How much of your credit are you using to currently run your business? And how much credit would you be able to access, if needed, in the future? The credit utilization ratio answers those two questions.

The ratio is the amount of your outstanding balances on all credit divided by the total credit you have available. If you had charged $15,000 on a credit card with a limit of $30,000 your credit utilization rate would be 50%. Or, if you have outstanding debt of $30,000 across all products (credit cards, lines of credit, and loans) and total credit available of $50,000, your credit utilization rate would be 60%.

The higher this ratio climbs, the lower your credit score and the lower your odds of being approved for new credit. It raises concerns about your businesses health and your ability to repay a loan.

What is DSCR?

Your debt service coverage ratio or DSCR measures the amount of free cash you have available to pay interest and principal payments on your debt. It measures whether or not your business is generating enough cash flow to pay your debt.

The underwriter calculates this ratio by taking your net operating income and dividing it by your debt payments. They might do it for an annual period or for a monthly period.

When calculating the ratio yourself, make sure that you use net operating income, not net income. The reason for this is that net income includes items like depreciation which are non-cash and not directly related to your business’ performance.

Taxes are also excluded, because they are somewhat outside of your control. As well, the amount you pay in taxes is not a reflection of how well you are managing your cash flow and business, so including them in the DSCR calculation would not give a lender the information they want.

Net operating income includes just your business’s revenues and directly-related expenses. You can divide it by your current debt payments to see where you stand at the moment. Then divide by your current payments plus any new payments after taking out a new loan. This gives you an estimate for the future.

A ratio below one indicates that you do not have enough income to service all your debt. If your ratio is exactly one before new debt payments are added you have no additional cash available to service new debt and are unlikely to be approved for a loan. Most lenders consider a ratio above one to be a good DSCR.

Common Mistakes when Calculating DSCR

If your DSCR looks odd to you, you might be making on of these common calculation mistakes.

  • Forgetting to Include Existing Debt. Your calculation should include both your current debt and your estimated payment on new debt. Lenders want to know your ability to cover all loan payments, not just their payment.
  • Not Accounting for All Kinds of Business Debt. Every single type of business debt payment should be included in your ratio. This means minimum payments on credit cards and lines of credit, other business loans, and any equipment financing loan payments, should be included in the denominator.

Other Ratios that an Underwriter Might Calculate

An alternative lender may stop once they have your credit utilization and debt service coverage ratios, particularly if they are both strong. However, if you are applying for a large loan amount they may want to look at additional financial metrics. These are good ratios for you to familiarize yourself with and use when trying to gauge your business’s performance, too.

Current Ratio

The current ratio measures your current ability to pay all expenses. It expresses the number of times that your current assets exceed your current liabilities by dividing your total assets by total liabilities.

If you had $450,000 of current assets and $250,000 of current liabilities on your balance sheet, your ratio would be 1.8%. The higher the ratio, the better.

Current assets are those that can be used to fund day-to-day operations and keep the lights on. They include cash and cash equivalents, marketable securities, accounts receivable, and any liquid assets. Large capital assets would not be included as they could not be sold and converted into cash quickly.

Similarly, current liabilities are those which could become due within one year, including accounts payable, accrued liabilities, and short-term debt.

The idea behind this ratio is to see if you would be able to handle all your current liabilities if everything came due at once. While this is extremely unlikely, it tells a lender if you can easily meet current obligations.

Interest Coverage Ratio

This is another ratio which analyzes your business’s ability to cover outstanding debt.  A higher ratio is better, in this case.

Using earnings before interest and taxes, divided by total interest expenses to get the interest coverage ratio. Now you know how much of your profits could be used to cover your debt.

This ratio is used less because it is rare that you would be making interest-only payments on a business loan. However, there are instances where this is the case and the principal comes due as a balloon payment at the end of the loan’s term and you might want to know this percent.

Debt-to-Asset Ratio

How many of your assets are financed by debt? This ratio will answer this question. Lenders prefer a lower ratio, and worry that you could be over-leveraged if it creeps upwards.

Divide your total debt by total assets to calculate the ratio. If you had debt of $150,000 and total assets of $175,000 your debt-to-asset ratio would be 86%. It could be difficult to qualify for a loan with this ratio. On the other hand, if you had debt of $150,000 but total assets of $300,000 your ratio would be 50%, which is much better.

Gross Margin

This ratio is more important to businesses that sell physical inventory. Take your gross profits, which is total revenues less cost of goods sold, and divided by total revenues.

If you had $80,000 in sales and a cost of goods sold of $35,000, you would take the net of $45,000 and divide by $80,000 for a gross margin of 56%.

This percent matters because, without significant gross margin to cover operating expenses, you will not have positive net income. Improving gross margin can only be done by cutting costs, but it may be necessary if your margin is low or starts to slip.

Net Profit Margin

How much money do you have left after paying all business-related expenses, not just cost of goods sold? This ratio measures the percent of net profit generated from business activities.

Simply divide net income by total revenue to calculate your net profit margin. In the above example, if your net income was $20,000 you would divide it by the $80,000 in sales for a 25% net profit margin.

If you do not have a positive net margin, you are not making money. A low margin could indicate that you are not effectively controlling costs to return a good profit. What is considered a “good” net margin varies significantly by industry.

In conclusion…

Not every financial ratio will be applicable to every business. Lenders who are experienced in your industry will have a list of ratios that they know apply. However, expect everyone, even alternative lenders, to look at your debt service coverage ratio.

If your skills as a business owner lie elsewhere, there are numerous online calculators which will calculate these ratios for you. Simply google “debt service coverage ratio” or any of the other ratios + calculator and you will find one.

Knowledge is power and, armed with the results of your calculations, you can determine if you can truly afford a business loan.

Dena Landon

Senior Writer at Shield Funding
Dena is a senior writer at Shield Funding, reporting on various topics related to small business loans and business financing. Previously her work has appeared on The Washington Post, Narrative.ly, Salon, and others. Her first novel was published by Dutton Children’s Publishing in 2005. She has a Master's in Business Administration from Capella University and has worked in the finance field for over fifteen years.