When your client is considering working capital, the first person they’ll probably come to for advice is you. And who better?
You’ll discuss many things: if they should even take on a loan, where they should go for a loan, and what type of a loan product they should consider. Once you’ve helped them come to a decision on each of these things, the next most important step is for you to walk them through the debt-service coverage ratio. Why? It helps them gain a real understanding for the loan amount their business can responsibly handle.
The debt-service coverage ratio (also known as the debt coverage ratio) is simply the ratio of cash a business has available to service its debt.
To break this down, when a lender is evaluating a potential borrower, the most important question they want answered is: can this borrower afford to pay me back? There are many details that go into providing that answer, but when it comes to figuring the actual loan amount, the debt coverage ratio is what they are going to calculate.
The easiest way to explain this to your client is to look at it from a monthly perspective (especially if they are in a short-term product). Tell them that lenders want to see, at the end of every month, after all expenses have been deducted, they have more than enough cash on hand to pay back their total loan payment for that month (principal and interest). This looks like:
Monthly Total Cash Flow/ Monthly Total Loan Payment = 1.25 or greater
So, if I have $5,000 in cash at the end of every month, and I am are expecting to pay $4,000 a month for my loan payments, I have exactly 1.25 times more cash every month than my loan payment. Lenders will want to see nothing less than 1.25 debt coverage ratio.
However, as you can probably tell, 1.25 times doesn’t really leave a lot of room for error. That being said, if your client’s cash flow is 1.5 times or greater than their potential loan payment, they’re in a much better position. If it is 2 times or greater, they are in an excellent position.
See for yourself: If I have $10,000 in cash at the end of every month, and am still expecting to pay $4,000 a month for my loan payment, my debt coverage ratio is 2.5, and I have a much better chance of qualifying for this loan (and will have an easier time handling the loan payments).
If your client is tight on cash, they are going to have a harder time qualifying for a larger loan. On average, borrowers are usually going to qualify for a loan size that is around 9 to 12% of their annual revenue.
There are certain circumstances when this won’t apply, but if you can educate your client on the debt coverage ratio and set their expectations early, the entire small business loan process will be much more efficient and easy.
Meredith Wood is Editor-in-Chief and VP of Marketing at Fundera, a marketplace for small business financial solutions. Specializing in financial advice for small business owners, Meredith is a current and past contributor to Yahoo!, Amex OPEN Forum, Fox Business, SCORE, AllBusiness and more.