When they are deciding whether to give you a loan, there are 2 main things banks want to know:
- Does your business have enough cash flow to repay the loan every month?
- Will you be able to do repayments on time?
In a previous post, I gave you an overview of the various sources of funding.
I know many of you are hoping to get a loan from a commercial bank. So today, I will show you some of the ways banks calculate what they are willing to lend to you.
Banks will always look at more than 1 thing. You can do the same calculations to decide whether to put in the time and effort to apply for a loan.
Note: there are other factors that banks also take into consideration that I discuss in this post. Note also that every bank has their own decision-making process.
The starting point
The starting point for a bank will always be your business plan, your business track record, your business financials and your collateral.
If you are just starting a business, it will be very difficult to convince any funder to give you money because you are considered high risk.
1. Minimum monthly revenue
Some banks will demand that the business should be making a certain amount of money before you can get a loan. They may also demand that you should have been making this amount for at least one year.
The maximum loan your business can get from banks – in the best case scenario – will be 2 to 3 times your monthly revenue.
Note: some funders may give up to 6 times your monthly revenue, but be very, very careful!
The interest they charge you will be so high that it may be better to call them loan sharks. Once they grab you, it is hard to get free from them.
Example: your business has been making USD 20 000 in sales every month. Your maximum loan amount will be USD 40 000 to USD 60 000.
2. Average bank balance
If you have a business account, banks will look at how much cash you usually have in your account.
If your business only has small amounts of cash in the account or if you are always struggling to make payments around the end of the month, you will be considered higher risk as compared to a business that has savings. Higher risk = reduced maximum loan amount.
3. Debt-service coverage ratio (DSCR)
Banks use DSCR to measure how much cash flow your business has to repay the loan. Your DSCR can determine whether your application will be approved. It can also determine the interest rate and the terms that the bank is willing to offer you.
Calculate the DSCR by taking your net operating income for a particular year divided by your debt service in that same year.
Net operating income = your sales minus all your expenses.
Debt service = the total amount of debt that you repaid or will repay
Banks want to see a DSCR that is at least 1.25 but they may require you to have a higher DSCR if the economy is unstable, if your industry is considered volatile or if your business is small.
Example: in 2019, your business had USD 40 000 in sales and your business expenses were USD 25 000. Meaning that your net operating income was USD 15 000. In 2019, you spent USD 11 000 to repay a loan (principal + interest). Your DSCR is: $15 000 / $10 000 = 1.36
If your DSCR = 1
It means that your business is making enough money to repay the loan but is not making a profit. The bank will consider you high risk and will likely reject your application.
If your DSCR is less than 1
Forget it. It means your business is not making enough money to repay the loan.
The DSCR can also tell you the maximum loan you should apply for. Calculate this by taking your net operating income and dividing it by 1.25 (the minimum DSCR).
Using the same example as above, your maximum loan is: $15 000 / 1.25 = $12 000. This means that your business can manage a loan of up to USD 12 000.
Note: if you are expecting additional debt, you need to subtract that debt from the maximum amount that you can borrow. For example, in addition to the loan that you are applying for, your business is also expecting another loan. You will be repaying USD 200 per month for this second loan. Meaning: USD 2 400 per year. In this case, the actual maximum loan your business can afford is: $12 000 – $2 400 = $9 600.
4. Debt-to-Income ratio (DTI)
This is another way for banks to determine if your business can sustain the monthly repayments. It is easy to calculate. Divide your monthly debt repayments by your monthly income.
Banks want to see a DTI ratio that is less than 35%.
For example: you are applying for a loan that you will repay at USD 400 every month. Your sales are USD 5 000 per month. Your DTI ratio is: 8% ($400 / $5 000).
But if your business is making USD 800 per month and you are applying for that same loan, your DTI ratio will be 50% ($400 / $800). The bank will reject your application
Your DTI ratio can also tell you the maximum loan your business can afford. Let us take the 8% DTI ratio from the above example and a maximum DTI ratio of 35%. In this case, your businesss has 27% “space” remaining for a loan (35% – 8%).
To now determine the maximum loan you can afford, multiply the monthly income by the 27%. Then times it by 12 to get to one year. I will use the same USD 5 000 in sales every month.
$5 000 x 0.27 x 12 = $16 200
5. Frequency of payments
This one is related to your sales and your debt.
- If your business depends mainly on a few customers, the bank will consider you higher risk.
For example: your business is making USD 5 000 per month in sales and that money is mainly coming from 2 customers. There is another business also making USD 5 000 per month in sales, but they have 10 customers each paying USD 500 per month.
Your business has a higher risk than this other business. Why? Because if you lose 1 customer, your sales will drop 50%. If the other business loses 1 customer, their sales will only drop by 10%. It will be easier for them to keep repaying the loan.
Note: if you can prove to the bank that your customers keep increasing, your loan application will get a higher score.
- The bank will also want to know if you buy on credit. If yes, from how many suppliers and how much you are paying them every month? In general, the less debt you have, the higher your application will score.
Even the most successful business can get hit by unexpected circumstances. These circumstances can damage your ability to repay a loan. The bank is aware of this. That is why they always demand collateral to protect their interest.
The type of collateral depends on your business assets. Assets = what you own. Do you have your own building, do you have trucks or personal savings? When you sign a loan agreement, you are authorising the bank to take whatever steps necessary to get their money back if you fail to repay.
Note: banks will not give a loan above 75 – 80% of the collateral that you are providing. Some collateral, like cars, will have even less value (maybe 30 – 40%). So if your collateral has a value of USD 40 000, your maximum loan may be USD 30 000 – USD 32 000. Even if the calculations say you can get USD 75 000, unless the bank likes your collateral, the loan amount will be lower!
When the bank is making calculations to determine how much money they are willing to lend to you, they will usually choose the lowest amount from the calculations. Why? Because this will reduce their risk.
If your bank is willing to tell you how they do their calculations, it can help you prepare for a loan application. Try and find out from the bank.
But even if they are not willing to tell you, the information in this post should help you understand where you stand and what chance you have to get a loan.