To avoid jeopardising your company’s financial future, make sure that you can actually afford a loan before applying for one.

Here’s how you can determine whether your business is financially secure enough for a loan.

Debt-to-income ratio

Lenders look at the borrower’s debt-to-income ratio – the ratio that measures the amount of debt against pre-tax income – to determine if they have the financial capacity to pay their debts. In this sense, most lenders require that borrowers have a debt-to-income ratio lower than 50 per cent.

For a new business, it’s also advisable to keep your personal debt-to-income ratio low and establish a good track record of paying your debts on time.

Debt service coverage ratio

Lenders also look at the borrower’s debt service coverage ratio (DSCR), especially if they are currently paying off another loan.

The DSCR calculates the ratio of cash that is available for debt repayments.

A common formula used to determine DSCR makes use of the company’s earnings before interest, taxes and amortisation (EBITA) and is calculated as follows:

DSCR = EBITA ÷ (interest + current maturities of long-term debt)

Lenders typically prefer borrowers with a DSCR greater than 1.0 because this shows that they have extra cash to use for repayments.

A DSCR below 1.0 means your business has a negative cash flow and you may have difficulty with repayments.

Calculate the amount of loan you need

As a small-business owner, financial institutions will consider your business as high-risk. Lenders may reject your loan if they think you’re borrowing an amount that your business will have trouble paying off.

Borrowing too much or too little money can affect your future cash flow. Too much loan means larger payments, while too little may result in insufficient funding for the loan.

The best thing to do is to find out how much your business really needs to borrow.

How to calculate the amount of business loan you need
To determine how much your business needs to borrow, you need to compute for it by preparing detailed financial statements and cost projections.

The cost projections should look into the actual cost of everything that the borrowed money will be spent on. Include your business’s cash flow (i.e. income and expenses) and other financial projections.

The financial statements, on the other hand, should include your actual or projected profit and loss and cash flow statements.

Financial statements are important because these documents will give you an idea of how much you can potentially use for repayments. It may also help lower your loan amount should you decide to partially fund your business needs using your profit.

Explore nestegg for more information about borrowing.