Perhaps your small business is growing and you want to invest in new equipment, marketing or a renovation. Or maybe your business has hit a rough patch and you believe that with the right investment you can turn things around. Either way, you’re looking for financing. And while getting a loan – any loan – may be your main concern, there’s an important question you will need to ask first: how much can my business borrow?
Brendan Ross, president of Direct Lending Investments LLC, the general partner of a short-term, high-yield, small business loan fund, has advice for “neighborhood businesses” looking for loans. These are small businesses, such as restaurants or car repair shops, for example, with monthly revenues of $20,000 to $200,000 hoping to borrow between $10,000 and $100,000.
Determining How Much to Borrow
Many times, owners of these types of businesses borrow to fund a project they believe will increase revenue, he says. A restaurant might borrow for a renovation or expansion that will add more tables, for example, or a firm might borrow for equipment that will allow them to make more of their product.
One way to look at the equation, then, is to estimate how much more revenue those efforts will bring in per day. For example, if you estimate those additional tables will bring in $500 in extra revenue daily, of which $300 will be profit, then you can plan to borrow based on that figure. Here’s how that works:
Most neighborhood businesses are going to find it difficult to find a low-rate bank loan, and instead will likely wind up with a loan that requires daily payments over the course of a year. If you take weekends out of the equation, that means 248 payments a year. In the example above, $300 in profit per day times 248 days equals $74,400 you could pay a lender over the course of the year.
Does that mean this borrower can afford a $74,400 loan? Not exactly. After all, there is interest to pay, and for this type of daily repayment loan it may range from 20%-30% or more. “They will probably borrow at about a 20 factor,” says Ross. “That means that if they borrow $1 they have to pay back $1.20.” And so that means the borrower in our example can probably borrow about $62,000.
But just because you can get approved for that size loan doesn’t mean you should take it. “If you think you can borrow $62,000 then borrow $31,000,” Ross warns. Otherwise, if things don’t go as well as hoped, you’ll be scrambling to make payments, find you have less money to take home, or worse, put your business in jeopardy.
“Business owners are notoriously challenged when it comes to being pessimistic about their plans,” he observes. And “it is not the kind of thing you want to be wrong about unless you want to explain to your spouse why there will be less money to spend for the year.”
Can a Lender Trust You?
For these types of loans, a lender will likely look at both your willingness and ability to repay the loan. Ross says that they will use your tax returns and a six-month bank history to figure out if you are able to handle the new loan payments. But for the willingness factor, they are very likely to look at the owner’s personal credit.
“When the time comes, if you protect your personal credit rating, then your business will be able to borrow more,” he says. In fact, in his experience strong personal credit is so important that he urges small business owners to do whatever it takes to make good on their obligations.
“The best thing a business borrower can do is protect their personal credit rating,” he says.
If you’re looking for a small business loan, it’s important to know where your credit stands. You can use a free tool like the Credit Report Card to monitor your credit scores and see the factors that are having the biggest impact on your credit. Also, it may be helpful to pull copies of your credit reports, which you can do for free once a year at each of the major credit reporting agencies.
More on Credit Reports and Credit Scores:
- The Credit.com Credit Score Learning Center
- What’s a Good Credit Score?
- How to Get Your Free Annual Credit Report
- How Do I Dispute an Error on My Credit Report?
- What’s a Bad Credit Score?
- How Credit Impacts Your Day-to-Day Life