There are many criteria that banks require in approving loans for businesses. What usually comes to mind first is credit, given today’s financial crisis. While credit is extremely important, there are many other factors in addition to credit scores that businesses must be aware of and account for when seeking capital for business growth. The following outlines a company’s ability to repay or service a new debt facility. Banks and other financial lenders will not just give you money because you think you need it; you have to be able to pay for it as well.
You must be able to repay your new debt – both the principle amount and the interest. Now, there are many structures to business debt like interest only (which I do not recommend), balloon payments, quarterly payments, etc. Still, you have to generate enough income from the business to service the payment amount. Further, not only do you have to generate enough money to pay the P & I, but you usually have to have a little bit more – usually 25% to 50%.
Why? This additional cushion provides the bank with assurance that your business could have a down period and still cover their payment.
Now to the numbers: To determine if your business could service a $100,000 business loan, begin with your net income. To this amount, add back depreciation (this is a non-cash accounting anomaly) and any and all interest payments that you already make and your taxes. This should be the net amount that your business has to cover your total debt service – this is essentially your earnings before interest, taxes, depreciation and amortization (EBITDA) or your actual cash profits from your operations.
For the remainder of this analysis, we will ignore taxes. The interest on your loan is an operating cost – meaning it reduces your taxable income. However, the principle portion that you pay comes straight out of your net income – after all other obligations are paid including local, state, and federal taxes. The reason we will ignore taxes is to make this analysis simple and demonstrate why banks and other financial lenders require higher debt service ratios.
At 8% for 48 monthly payments, a $100,000 loan would require a monthly service of $2,442 or $29,296 per year (straight amortization for simplicity purposes). Assuming that your business does not have any other debt, you would have to, at the least, earn this amount over and above all other business costs – over your EBITDA. However, most banks want to see a debt service ratio of 1:1.25x to 1:1.5x – meaning that you need to generate EBITDA between $3,053 and $3,663 per month in this case.
Should your business have other debt that is not being paid off with this new facility, add that amount to your debt service minimum payment above. You will then have to cover up to 1:1.5x all your debt obligations.
Further, banks do "what if" analysis on this debt service requirement. Take your operating profit (EBITDA) and reduce it by 10% and 20%. After these calculations, does this new income amount still cover the original payment amount of $2,442? If not, no loan. Again, banks want to ensure that your business could survive a down turn and still make its payment obligation to them.
Keep in mind that the above analysis is based on past financial (past results of your business). While the lender will make every attempt to forecast future projections, it does not significantly rely on expectations of what your business will or may do.
While this is a very basic analysis, I hope you get the gist of what banks look for when underwriting loans. Should your business not be able to meet these requirements, then negotiate a lower payment through interest reduction, loan amount reduction, or balloon payments or reevaluate your need for a loan. If you can’t pay for it, you don’t need it.
Additionally, there may be many other ways to finance your growing business. The most widely used for working capital loans and advances are accounts receivable financing (factoring), purchase order financing, and business cash advances. These types of facilities can help bridge the gap between cash outlay and revenue.
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