Can You Afford a Bad Credit Business Loan?
Small business owners often start their business with a dream. The dream of filling an unmet need in the community, or growing into a national franchise, or they might want to launch a product that they think the world needs. Whatever your dream, at some point you will need capital, typically obtained in the form of a small business loan. When deciding whether or not to take out a loan, do not forget to look at its affordability.
If you have bad credit, you will not be approved for prime lending. Banks and traditional lenders will consider you to be too much of a risk. While you still have options, particularly through alternative lenders, these lenders will charge higher interest rates to offset their risk. The interest rate is, essentially, the profit the lender sees for letting you use their capital. Charging a higher rate lets them recoup more of their money up front, in case you don’t repay the principal.
This higher interest rate means that bad credit business loans will be more expensive to you, the borrower. Since the loan will cost you more, the question becomes, can you afford it?
Put Together a Small Business Loan Spreadsheet
To determine if you can afford a bad credit business loan, crunch some numbers. If you do not have a monthly budget for your business, now is the time to put one together. Deduct all your monthly expenses from your revenues. A positive difference is excess cash flow and a negative difference means that you are in the red.
The excess, or positive difference, is the amount of money that you have available for additional payments, such as a loan payment. To find out what your loan payment could be, input the loan’s capital, interest rate, and term, into a simple online business loan calculator. It will return an estimated payment amount. It will not be an exact amount unless you know every fee your lender will add to your loan.
Add that payment into the expenses side of your budget and see where you stand. Does it stretch your cash flow to the limit? Or will you have a comfortable cushion?
Not all business loans are paid in monthly installments. Some have balloon repayment options, where the borrower makes interest-only payments until the entire capital comes due in one lump sum. Other lenders, particularly alternative lenders, will work with a business to determine the best payment schedule for them. Payments could be monthly, bi-weekly, or even daily.
If you plan on setting up a different repayment plan, create a spreadsheet calculating every payment until the small business loan has been paid off. Make sure that you lay it out in black and white so that you are not making an emotional decision.
Calculate Debt Ratios
Debt and profitability ratios can also be helpful to guide your borrowing decision. Be aware that any lender you approach will also calculate these ratios, and is unlikely to approve you for a loan if they indicate that you cannot make the loan’s payments.
Your business’ debt service coverage ratio (or “DSCR”) measures your ability to cover debt obligations. It’s calculated by taking your net operating income and dividing it by your total debt service. Net operating income is revenue minus operating expenses, which you should already have calculated when preparing your budget above. Total debt service is your total debt payments, i.e., interest plus principal.
Once you have a current DSCR, add the amount of any new loan payment to your existing debt service. This will tell you if you can truly afford that new small business loan. The ratio can also be used to calculate the impact that different loan products could have on your business.
If you only calculated your DSCR with just the loan payment on the bad credit loan, you should also look at your debt-to-income ratio. The debt-to-income ratio encapsulates whether or not you can afford a loan within the context of all your debt obligations. Divide all your debts by your monthly gross income and multiple it by 100 to get a percentage. This shows you how much your income exceeds, or falls beneath, your debt payments.
Calculate Profitability Ratios
Another good ratio to look at is your return on investment, or “ROI. It represents the potential gain, or loss, on an investment. If you are considering borrowing so that you can invest in growth, whether it is a new capital asset or an expansion, a good rule of thumb is that your ROI should be higher than what you are paying to borrow that capital.
The formula for ROI is to take the current value of the investment, subtract the cost of the investment, and then divide it by the cost of the investment. Not only should the return be positive, but calculating the different rates of return on various investment options can help you choose between them.
In general, when deciding whether or not you can afford a bad credit business loan you will want to know if your existing revenues can cover the payments and if it will add enough value to your business to outweigh the higher interest rate.
Evaluate your Current and Expected Cash Flows
Without free cash flow it will be impossible to qualify for a loan. Lenders will be concerned about your repayment ability. While a net positive in your budget is good sign, so, too, is your current ratio.
The current ratio takes your current assets and divides them by your current liabilities. Current assets are those that can be turned into cash quickly, so items such as large equipment and buildings will not be included in this amount. Current liabilities are generally amounts due to others within the next year.
Depending on the business, a current ratio of less than one is alarming to most lenders. It indicates that you do not have the capital to pay your current debts, so why would they lend you more? But a current ratio of less than one can be caused by something as simple as the day of the month it is calculated. The timing of cash inflows and outflows can impact the ratio, which is why it is best to look at a trend.
While a lender might only look at existing cash flow when making an approval decision, as a business owner you can also take into account expected cash flows. The capital that you hope to borrow will be supporting a business plan, often growth or expansion. If you add the amount of revenues that you expect your investment to generate to your current cash flows it could have a large impact on your ratios. It is true that, often, you have to spend money to make money.
Prepare a Loan Performance Analysis
Taking out a bad credit business loan should be a good decision overall for your business. Remember, obtaining more capital should lead to increased revenues. Knowing that the loan will help you grow, and having a good idea of the amount of new revenues it will generate, informs your borrowing decision and helps you calculate many of the metrics above.
A loan performance analysis takes into account the loan amount, its interest rate, and the loan’s term and compares them to your current annual revenues, the growth in revenues that you expect the loan to generate, and the length of time you think you will receive its benefits. Extend the analysis over time to determine in which year you will break even on the loan, and when it will become a positive for you.
If the loan performance analysis indicates that you will never break even, or generate money from the loan, than you cannot afford a bad credit business loan.
What Do All the Numbers Say?
Once you have put together a budget, calculated ratios, and analyzed a loan, whether or not you can afford a bad credit business loan should be evident. Numbers cut through the emotional pull you may feel to expand or grow your business to tell you if your plan is truly feasible.
A lender will request financial and bank statements to make the same determinations when making a lending decision. If your numbers do not support the loan you are unlikely to be approved for it. Still have questions? Talk to the loan experts at Shield Funding for answers.