For years, business have happily applied for working capital loans, invoice (bill) discounting, collateral free loans and small business loans in order to improve and expand upon their business.
Whether it is required for emergency cash relief in a period where working capital has been tied up, or the money has been required to facilitate growth of the business by expansion, purchase of fixtures and fittings or even hiring new staff, the requirement of having cash from borrowed funds is there for almost everyone.
Yet, it is amazing how most business owners completely forget the flip side of the coin, about whether they can actually afford to repay the loan or not.
It definitely is something to consider, after all, life is tough enough as it is with paying your vendors, employees, overheads and maintaining your machines, without having to also add to this with a loan repayment plan which your cash inflows simply cannot afford.
If this were to take place, you would be in the unfortunate position of getting into a debt trap, whereby you would constantly be borrowing more funds (or injecting your own) simply to repay the debts owed to the lenders, and that is by no means good for your business, as it takes your focus away from concentrating on your business operations and strategy, and if that leads to declining revenues, well, then, you are creating even more problems for yourself!
Now you know about the importance of working out debt affordability, we come to the question of how to determine whether you can take on debt. Thankfully, we at MarketFinance have come up with easy to use solutions which will help in alleviating that particular problem.
The easiest way to think about it is this:
What is my free cash flow? –
This is cash generated by the business after deducting for expenses such as inventory, overheads, maintenance, payroll and anything else which is strictly for business operations. Note that this does not include:
- Cash used to purchase machinery
- Cash used to pay directors’ salaries or dividends to shareholders
- Cash used to repay interest on existing overdraft facilities or EMIs for existing business loans (or EMIs for directors’ loans)
- Cash earned in fixed deposits which the business may have
- Any one off cash income or expenses generated which are not part of regular business operations
Why are we doing this? The answer is because we want to look solely at net cash generated from business activities alone.
After all, this is what you set up your business for, and if your cash generated from business activities is less than your cash expended due to business activities, then clearly this will mean you do not have enough cash to be able to meet any debt and interest payments if you were to acquire a loan.
Whilst this may make sense to you, it sure is a difficult problem trying to work this out, especially if your business has loads of bank transactions taking place every month. Worry, not, help is at hand here too!
Simply do this:
- Take your business’ monthly net profit before tax (ie – Total monthly turnover – Monthly cost of goods sold – monthly overheads)
Add back the following:
- Directors’ salaries
- Interest paid from finance costs
Also deduct the following:
- One off revenues earned which are not part of regular business activities
- Finance income from investing the business’ cash into short term investments like fixed deposits and mutual funds
What you have here is Earnings before interest, tax, directors’ salaries, depreciation and amortization (EBITDDA). This serves as a rough and ready proxy of your cash flows from operations.
Hopefully this number is positive, because if it is negative then this already implies that you won’t be able to take on debt, as your business is still not sustaining itself.
- Next, we need to see what your monthly loan repayment schedule looks like. Simply take your existing EMIS, and add them together to give you your total monthly loan repayment schedule. I would also recommend you put in your average monthly overdraft/cash credit/invoice (bill) discounting interest in there as well, because this too is a financing activity, which needs to be repaid.
- Now simply do the following:
Voila! There you have it. You have calculated your DSCR, which officially helps you determine whether you can afford to take on a new/additional loan.
The Ideal DSCR
As a general rule of thumb, having a DSCR of more than 1 indicates that you are in a position to take on (and repay) more debt. If your DSCR comes in at 0.95 for example, it means that your business is only currently able to repay 95% of the existing debt, and therefore, it is unlikely for any lender to want to lend to you.
It should be noted that the DSCR calculation will differ based on the lender who is performing the calculation, but that the above can and should be used as a good yardstick for determining the ability to repay your loan.
With this to determine if you can afford your business loan, you’re well equipped to know exactly what you’re getting into before taking it on.
Remember, paying back a loan will cut into your cash flow. So if you’re using a loan to solve cash flow problems, make sure that the loan won’t put you worse off.
And on the brighter side of things, if you’re using the loan to grow your business—maybe open up a new location or develop a new product line — you want to be confident that you’ll make some return on investment.
Calculating your DSCR before you take on a loan is a sure way to see what you can afford!