Patrick Del Rosario is part of the team behind Open Colleges—one of Australia’s leading providers of Open Colleges Accounting courses and Bookkeeping Courses. When not working, Patrick enjoys blogging, traveling, and photography. Patrick and his father run a Photo Studio in the Philippines.
At one time or another, most businesses will need to take out a loan from a bank or other lender. While this process might seem a bit daunting, your chances of being granted the business loan you need all boil down to a simple concept: capacity.
What is capacity? Where banks and loans are concerned, capacity refers to a business’s ability to repay the loan on time. A successful application for a business loan will require you to prove your capacity using your company’s revenue, expenses, cash flow, credit history, and other financial factors.
Before you begin a loan application, it’s a good idea to make sure that your capacity will satisfy the bank’s loan requirements. There are three simple tests you can use to determine whether or not your business’s capacity will meet your lender’s standards.
1.) Calculate Your True Net Income
The bank will want to ensure that your past cash flow could have covered the principal portion of the loan. Most lenders will analyze the past three years of financial statements for your business to make this determination.
If you’d like to preemptively spread your financial statements to see what the bank will discover, do the following calculation for each of the past three years (monthly, quarterly, or annually, depending on the preference of your lender):
- Add any one-time past expenses (items your business won’t need to pay for again) and non-cash accounting items (such as depreciation) to your business’s net income.
- From this total, subtract the amount representing what you’ll pay in interest for the proposed loan.
You now have a truer net positive for your business’s net cash flow. If this amount can cover the principal of the loan you wish to take out, you’re on your way! However, it’s important to keep in mind that most lenders will want this calculated cash flow number to cover 25 to 50% more than just the minimum principal of the loan in question. This is done to ensure that even if your business goes through a slow period, you’ll still be able to pay off the loan principal.
If you’ve spread your financials and determined that you’re business would have been able to pay off the proposed loan plus 25 to 50%, then congratulations – time to move onto the second step.
2.) Spread Your Financials with Lower Revenue Totals
It’s now time to calculate how your business would do if your revenue was reduced. This and other “what if”-type scenarios will be calculated by your lender to reassure them that if your business suddenly slows you’ll still be able to repay your loan.
Perform the above calculation again, keeping all your expenses the same but reducing your revenue anywhere between 10 to 20%. (Don’t forget to add back any one-time expenses or non-cash accounting items.) Would your business’s new calculated cash flow still be enough to pay back the loan? If so, then you’re even closer to securing the loan you need for your business.
3.) Examine Your Debt-to-Equity Ratio
Banks are in the business of worrying about “what-if” scenarios – so you have to be too. If the market crashed or you were forced to shut down your business, would you still be able to pay back your loan?
Banks perform a calculation called the debt-to-equity ratio to determine what would happen in that unlikely scenario. Most businesses have a debt-to-equity ratio between 1.5 and 2 – banks consider this a safe ratio when it comes to lending. You’ll want to ensure that your business falls within the approved range.
To calculate your company’s debt-to-equity ratio, all you have to do is divide your total liabilities by your total equity. If your number is 3 or above (meaning your business has three times as much debt as it does equity), your business is probably relying too heavily on debt financing and would be considered too much of a risk to receive a bank loan. But if you fall in the 1.5 to 2 range, congratulations – you’ve passed the third test for guaranteeing your capacity to pay back a business loan!