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By Carl Faulds

When you’re seeking financing, particularly financing to power growth, it’s all too easy to overlook one important question: Can your small business actually afford the borrowing? Here are steps to take to determine whether your small business can afford a loan.

Calculating your debt service coverage ratio

To understand what you can borrow, you first need to know what you can afford to repay. In turn, this will require you to calculate your debt service coverage ratio (DSCR). Put simply, the DSCR is the ratio of cash you have available to service debt (which could mean repaying capital or paying interest and fees).

The calculation can be made in several ways, but we’ll simply discuss the two most common options. One formula is as follows:

(Annual net operating income) – (Depreciation and other non-cash charges )/ Interest + Current maturities of long-term debt

Alternatively:

(Earnings before interest, taxes, depreciation and amortization-EBITA) / (Interest) + (Current maturities of long-term debt)

So for example, if your net operating income is \$64,240 and your loan will cost you \$51,392 each year, your DSCR would be 1.25 (\$64,240 / \$51,392). Clearly you need to factor other borrowing into the equation, so if you will be paying \$12,848 to another lender then your DSCR is reduced to 1.0.

Should your DSCR fall below 1.0, you will find yourself with a negative cash flow. For instance, a DCSR of 0.9 would mean that you could cover only 90% of your debt repayments and would have to use your personal finances to make up the shortfall. In general, lenders will decline to do business with you in this situation, though there may be some exceptions.

Every lender has different criteria when it comes to evaluating your DSCR. Most will play it safe and consider 1.25 the minimum to approve a loan, while others will be more cautious and consider 1.35 the minimum acceptable. Furthermore, these criteria may not be fixed—they may vary across different types of loan and are likely to be reviewed regularly as the economy moves from boom to recession and back again.

RELATED: 10 Key Steps to Getting a Small Business Loan

You should also be prepared for lenders to ask for your DSCR from previous years to give them an idea of trends in your company’s finances, particularly if you’re in a phase of rapid growth.

Another way of evaluating whether you can afford a small business loan is to look at your debt-to-income ratio. This approach, in contrast, considers a loan’s affordability within the broader context of your other debts.

To make the calculation, you should calculate all your personal and business debts—including everything from corporate loans to personal mortgages—then divide the sum by your monthly gross income. Multiply the final figure by 100 and you have a percentage that tells you how much your income exceeds your debts (or falls below it, if your finances are in a poor state).

This is a much less useful calculation to assess your readiness to borrow, but it will give you a broad sense of how you are performing financially. In general, if your debt-to-income ratio is more than 36%, you should think twice about taking on additional borrowing—and be prepared to face rejection if you go ahead.

Introducing loan performance analysis

Finally, if you want to evaluate your financial position from a further perspective, you should consider loan performance analysis. This approach differs from the debt service coverage ratio and the debt-to-income ratio in that it examines both sides of the equation—the financial risks of taking on additional borrowing versus the potential rewards of investing in business growth.