If your small business is experiencing growing pains, it may be time to apply for a business loan. Whether you’re investing in marketing initiatives, testing new products or moving your company out of the basement, a loan can push your business to the next level. But how much money does your small business qualify for? Let’s take a look at the basics so you can make the best decision for your situation.
Lenders use a variety of tools to decide whether you’re a good candidate for a loan and how much you’re qualified for. One of their primary ways is the debt service coverage ratio (DSCR), which is the amount of cash needed to make payments on your debt. Let’s break down the considerations for the DSCR.
To get started, determine your monthly cash flow. Add the money you have on hand at the beginning of the month (starting cash) to the money that comes in throughout the month (cash-in) and subtract the money going out (cash-out). Once you have this number, multiply it by 12 to get your annual cash flow.
The next step is to calculate the annual debt payment on the proposed loan. While you won’t have a concrete number at this point, you can estimate it based on the amount you know you need to grow the business and approximate interest rates from the lending institution you wish to use.
Once you have these numbers, use the following formula to find your DCSR:
Debt Service Coverage Ratio (DSCR) = Annual Cash Flow/Annual Debt Payment
With both numbers calculated, you arrive at the final DCSR. If the ratio rests between 1.15:1 and 1.25:1, you’re usually in good territory and will be able to afford and secure financing.
What Factors Impact Qualifying for a Loan?
The DCSR isn’t the only factor lenders use when considering you for a loan. They also look at details like the amount of time you’ve been in business, industry risk, credit scores for you and the business, financial records, collateral and access to capital, debt-to-income (DTI) ratio and even your social media accounts, both personal and professional.
Lenders will ask you about financial projections—your P&L statement and cash flow statement—too, in an effort to decide if you’re a good investment. The key here is to not ask for too much or too little. Be realistic. By digging into your financial reports and coming up with some hard numbers, you can ask for and get the loan you want.
What Documentation Is Needed When Applying for a Loan?
Be prepared to wade through the paperwork when beginning the loan application process. As we mentioned, lenders will ask about financial results and projections, data found in balance sheets, cash flow statements and P&L reports. Compile the information and bring it with you when applying for a loan.
You should also expect to be asked about your business plan and model. While you don’t need to write out a 55-page plan, you do need to provide a proof of concept. Some lenders will want to see resumes and profiles for you and the people involved in the business; others won’t. Incorporating the information in your loan documentation doesn’t hurt you either way, so go ahead and include it.
Lenders will also ask about personal financial information going back three years. To meet this requirement, you should bring copies of your last three tax returns. You will also want to have your latest credit score report.
Some loans have special conditions and may require you to submit legal documents, too. If that applies to you, you’ll want to have the correct documentation on hand. Common legal documents include business licenses and registrations, articles of incorporation, franchise agreements, contracts with third parties and commercial leases.
You should also be prepared for in-person questions. Lenders will ask why you’re applying for a particular loan, what you plan to do with the funds, what other assets you’ll need to purchase, who your suppliers are, and what business debt you already have. The questions may seem probing, but they’re for your and the lender’s own good. They ensure you’re ready to take the next step with your business.
Take Your Next Step as a Small Business Owner
Applying for a loan may take time and effort, but the rewards are worth the investment. By figuring out why you need a loan and how much to ask for, you can pursue the type of loan that suits your circumstances. You may require a line of credit. In other scenarios, a personal loan or a business loan may be the better choice.
Once you’ve made the decision, the rest of the process is gathering paperwork and making your case as the best loan candidate. The work may be tedious at times, but you’ll be glad you’ve done it—it always pays off. You’ll get the loan you want, at the interest rate you need, and be able to successfully grow your business.