How Much of a Loan Can I Afford? A Guide for Small Businesses

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.

How Much of a Loan Can I Afford?

To determine how much of a loan you can afford, consider your business’s current financial health, cash flow for monthly repayments, and the loan’s purpose and terms. Analyze your debt service coverage ratio (DSCR) to gauge repayment capacity.

Reflect on personal financial commitments and the overall impact on your business’s financial stability. A careful assessment ensures you choose a loan amount that matches your repayment abilities without straining your business finances.

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.

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.

Understanding Loan Affordability: Key Considerations

Before applying for a loan, it’s crucial for small business owners to carefully evaluate their capacity to take on new debt. Here are key considerations to help determine loan affordability:

• Assess Your Debt Service Coverage Ratio (DSCR): Calculate your DSCR by dividing your business’s net operating income by your total debt service. A DSCR greater than 1 indicates that your business generates sufficient income to cover loan payments. A lower ratio may signal potential repayment challenges.
• Evaluate Your Cash Flow: Analyze your cash flow statements to understand the timing and amount of cash inflows and outflows. Consistent positive cash flow is a good indicator that your business can afford to service a loan.
• Consider the Purpose of the Loan: Align the loan with a specific business need or growth opportunity that will generate additional revenue. Loans used to fund activities with a high return on investment (ROI) are generally more justifiable.
• Factor in Interest Rates and Fees: Understand the total cost of borrowing, including interest rates and any associated fees. Higher rates increase the overall cost of the loan, affecting its affordability.
• Prepare for Economic Fluctuations: Consider the stability of your industry and potential economic downturns. Building a buffer into your financial projections can help ensure you can afford the loan even if business conditions change.
• Review Your Personal Financial Commitments: If you’re required to provide a personal guarantee, assess how this obligation fits with your personal financial situation. Ensure you can meet both your personal and business financial commitments.
• Analyze Loan Terms: Longer loan terms can reduce monthly payments but increase the total interest paid over the life of the loan. Shorter terms have higher monthly payments but lower overall costs. Choose terms that align with your cash flow and repayment capacity.

Legal and Compliance Considerations for Business Loans

Understanding the legal and compliance aspects of business loans is crucial for small business owners. Here are key points to consider:

• Loan Agreement Terms: Review the loan agreement carefully. Pay special attention to the interest rate, repayment schedule, collateral requirements, and any covenants or conditions.
• Personal Guarantees: If a personal guarantee is required, understand the implications for your personal assets. Ensure you’re comfortable with the level of personal risk involved.
• Compliance with Lending Regulations: Familiarize yourself with relevant lending regulations, including the Truth in Lending Act (TILA) and the Equal Credit Opportunity Act (ECOA). These regulations protect borrowers by ensuring transparency and fairness in the lending process.
• Collateral Requirements: If collateral is required, understand what assets can be used and the potential impact on your business and personal financial situation if you’re unable to repay the loan.
• Prepayment Penalties: Some loans include penalties for early repayment. Consider how this could affect your flexibility to pay off the loan sooner if you have the means.

Planning for Repayment: Strategies for Success

Successfully repaying a business loan requires careful planning and management. Here are strategies to help ensure you can afford your loan repayments:

• Build a Repayment Plan into Your Budget: Incorporate loan repayments into your business budget. Regularly review and adjust your budget to ensure you can meet your obligations.
• Prioritize Debt Repayment: Treat loan repayments as a non-negotiable expense. Consider setting up automatic payments to avoid missed or late payments.
• Maintain an Emergency Fund: Build and maintain an emergency fund to cover unexpected expenses or fluctuations in income. This can provide a financial cushion and prevent disruptions in loan repayment.
• Monitor Your Financial Performance: Regularly review your financial statements to monitor your business’s performance. Address any issues promptly to avoid negatively impacting your ability to repay the loan.
• Communicate with Your Lender: If you anticipate challenges in making loan payments, communicate with your lender early. They may be able to offer solutions such as loan restructuring to help you manage your repayments.

Conclusion: How Much of a Loan can I Afford?

Determining whether you can afford to apply for a business loan involves a comprehensive assessment of your business’s financial health, the cost and terms of the loan, and your personal financial commitments.

By carefully considering these factors, you can make an informed decision that supports your business’s growth and financial stability.

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