There’s a lot for a small business owner to think about when preparing a business loan application.
But before you begin to compile documentation, take a step back and ask yourself — How much of a loan can I afford?
What will I qualify for?
Can I afford the repayments?
Does my business have the revenue to actually make the loan payments?”
In short, do you have the ability to pay for this business loan?
Asking these questions will help you think about the loan process from the lender’s point of view.
Can You Pay Back the Loan?
Most lenders use varying tools to determine if your business is worthy of a loan, and whether or not you can, in fact, pay it back.
One tool is a debt service coverage ration (DSCR), which compares the cash that you have available as a business owner (to pay back the loan) and the amount of money you hope to borrow per year, including interest.
Generally, banks are more comfortable offering assistance to businesses that have been in existence for a number of years and have a proven financial track record.
If your business has consistently made a profit and that profit can cover the payment of additional debt, it is likely that your loan will be approved.
If however, your business is a startup or has been operating marginally and has an opportunity to grow, you need to prepare a thorough loan package with a detailed explanation including how the business will be able to repay the loan.
More Importantly, Will You Pay Back the Loan?
Lenders look at more than your business’s finances when they evaluate your loan application. They will also look at you, the business owner, and will likely use another tool to determine your personal aptness for a loan — your debt-to-income ratio.
They’ll evaluate your monthly personal debts (including things like credit card payments and car loans) as well as your housing expenses (mortgage payments as well as homeowners insurance, property taxes, etc.). They’ll divide your total monthly debts by your monthly gross income to get a percentage.
Most lenders prefer debt-to-income ratios under 36 percent.
You can get a step ahead here by calculating your debt-to-income ratio yourself to see if your income far exceeds your debts. If it does, a lender may add some of the excess income to your business’s available cash, which can be helpful for businesses with DSCRs that need a boost.
Lenders may also use your personal credit score to decide if you are worth the risk, ensuring that you have a history of paying your bills. Banks and other traditional lending institutions may place a greater emphasis on credit scores, so if your personal credit isn’t great, you may want to look for other, alternative loan options that are more flexible.
Be Sure to Ask Yourself, “What If?”
Even if you know that you can and will pay back your loan, you have to consider the toughest question of them all — what would you do if you can’t pay it back?
Even with the best intentions and responsible planning, all business owners must have a plan in place in case the business does not work out. A typical backup plan might include assets or collateral that the bank can claim if you’re unable to pay back your loan, or an extra source of cash float that can go toward loan payments.
For many small business owners who don’t have that cushion, the backup plan could be what a lender might call a “personal guarantee” — a promise that if you can’t pay back the loan through your business, you’ll pay it out of pocket.
It goes without saying that assuming personal responsibility for business debt comes with a lot of risk, so be sure to consider your decision carefully. If every single part of your business plan would have to play out perfectly in order for you to pay back your loan, then it may not be time to apply for one yet.
Once you can address the questions above, you’re ready to decide if you should move forward with the loan application process.
Factors to Consider When Determining What Loan Amounts
When determining how much of a loan a small business owner may be able to afford, several factors come into play. These considerations are essential in ensuring the loan is beneficial to the business’s growth and sustainability and doesn’t become a financial burden.
- Current Financial Health: One of the first things lenders look at is the current financial health of the business. A company with steady cash flows, healthy profit margins, and manageable debt will likely be able to afford a larger loan compared to a business with erratic income and towering liabilities.
- Projected Cash Flows: Loans are typically paid back in monthly installments. It’s crucial to project future cash flows to ensure that the business can meet these monthly payments along with other operational expenses. This projection should be based on realistic and conservative estimates.
- Purpose of the Loan: The reason for borrowing should also dictate the loan amount. If the purpose is to finance a project with a high ROI, then taking a larger loan might make sense. However, if the loan is for covering operational expenses, it’s better to consider if the business model is sustainable or if other financial adjustments should be made.
- Interest Rates and Loan Terms: The interest rate on the loan and the repayment term play a significant role in determining the total cost of the loan. A lower interest rate or a longer term might mean lower monthly payments, but the total interest paid over the loan’s life could be higher.
- Economic Environment: If the economic environment is volatile or a downturn is anticipated, it might be prudent for business owners to borrow conservatively. An unpredictable market could impact the business’s ability to generate revenue and pay back the loan.
- Personal Financial Stake: Sometimes, business owners may need to provide personal guarantees or collateral for a business loan. It’s crucial to understand the implications of this and to consider how much personal risk one is willing to take.
- Other Existing Financial Commitments: It’s also essential to factor in other financial commitments the business may have. These could include leases, other loans, or contractual obligations that require monthly payments.
| Factors for Determining Loan Amounts | Description |
|---|---|
| Current Financial Health | Lenders often start by assessing the business's present financial status. Businesses with consistent cash flows, commendable profit margins, and minimal debt are generally more eligible for larger loans. Conversely, businesses with unstable income and significant liabilities may find it challenging. |
| Projected Cash Flows | To determine loan affordability, it's vital to anticipate future cash flows. This ensures the business can handle loan repayments alongside other operational costs. It's important to base these projections on realistic and conservative estimates. |
| Purpose of the Loan | The intention behind borrowing greatly influences the loan amount. For projects with high expected ROI, a larger loan may be justifiable. But if the loan aims to cover daily expenses, it's worth reevaluating the business model and financial strategies. |
| Interest Rates and Loan Terms | The loan's interest rate and its duration significantly dictate its overall cost. While lower interest rates or extended terms might reduce monthly payments, they can also lead to higher total interest expenses over time. |
| Economic Environment | The broader economic landscape plays a role in loan decisions. During uncertain or predicted downturns, it may be wise to borrow cautiously, as unstable markets can affect revenue generation and loan repayment capacity. |
| Personal Financial Stake | Occasionally, lenders may require personal guarantees or collateral. Business owners should fully comprehend these stipulations and gauge the personal risk they're prepared to assume. |
| Other Existing Financial Commitments | Beyond the new loan, it's crucial to consider the business's ongoing financial obligations, like leases, existing loans, or other contracts with recurring payments. Balancing these alongside a new loan is essential for maintaining financial health. |
Determining the right loan amount is a balancing act. It requires a thorough analysis of the business’s financial situation, understanding the broader economic landscape, and recognizing the personal risks involved. Before making a decision, it’s advisable to consult with financial advisors, accountants, and possibly peers in the industry to get a comprehensive perspective.
Tips for Small Business Owners Applying for a Loan
Applying for a business loan can be a critical decision for many small business owners. While loans can provide necessary capital for growth or to bridge financial gaps, the application process can be daunting. Here are some tips to help small business owners navigate the loan application process more effectively:
- Research Different Loan Options: Not all loans are created equal. Different financial institutions offer various loan products tailored to specific needs, whether it’s for startup costs, inventory, expansion, or other reasons. Understand the different types of loans available, such as term loans, lines of credit, equipment financing, or SBA loans, to determine which best suits your business’s needs.
- Prepare Financial Documentation: Lenders will want to see evidence of your business’s financial health. This could include profit and loss statements, balance sheets, cash flow statements, and tax returns. Make sure all your documents are up-to-date, accurate, and organized.
- Understand Your Credit Score: Both personal and business credit scores might play a role in your loan approval process. Ensure you know what your credit score is, and if there are any discrepancies, address them before applying.
- Create a Solid Business Plan: Lenders want to know how you plan to use the money and how you will repay it. A clear business plan that outlines your business goals, market analysis, revenue projections, and strategies for success can make a difference.
- Consider the Cost of the Loan: Beyond just the principal amount, understand the interest rates, fees, and other costs associated with the loan. This will help you determine the true cost of borrowing and ensure that you can manage repayments.
- Build a Relationship with Your Lender: Establishing a good rapport with your lender can be beneficial. Whether you’re working with a traditional bank, a credit union, or an online lender, try to establish a relationship where they understand your business and its needs.
| Tips for Small Businesses Applying for a Loan | Description |
|---|---|
| Research Different Loan Options | Not all loans are created equal. Different financial institutions offer various loan products tailored to specific needs. Familiarize yourself with different types of loans, such as term loans, lines of credit, equipment financing, or SBA loans, to find the best fit for your business. |
| Prepare Financial Documentation | Lenders will require evidence of your business's financial health. Ensure you have ready and updated documentation like profit and loss statements, balance sheets, cash flow statements, and tax returns. They should be accurate and organized. |
| Understand Your Credit Score | Your credit score, both personal and business, can significantly impact your loan approval. Know your score beforehand and resolve any discrepancies before applying for a loan. |
| Create a Solid Business Plan | Lenders want to see a clear plan on how you'll use the funds and repay them. A detailed business plan with goals, market analysis, revenue projections, and strategies for success is essential. |
| Consider the Cost of the Loan | Look beyond the principal amount. Understand the interest rates, fees, and other costs associated with the loan. This helps you determine the total cost of borrowing and ensure manageable repayments. |
| Build a Relationship with Your Lender | Cultivate a good relationship with your lender. Whether you're engaging with a traditional bank, credit union, or an online lender, a rapport helps in understanding your business needs and facilitates smoother communication. |
Preparation and due diligence are key when applying for a business loan. Small business owners should approach the process with clarity, ensuring that they not only secure the best terms but also that they’re making informed decisions for the well-being of their business.
This article, "How Much of a Loan Can I Afford? A Guide for Small Businesses" was first published on Small Business Trends