How Much Should You Borrow for Your Business?

How much money can you borrow for your business?

How much money you can borrow starts with the types of loans a lender offers and the ranges they’re willing to offer for each type of loan. The table below offers an estimate of the typical ranges you can expect to see for different loan types.

However, just because the maximum term loan a lender offers is $3 million, for example, doesn’t mean you’ll qualify to borrow that much. How much a lender will actually offer you depends on your business’s circumstances, including factors like your credit score, average monthly revenue, cash flow and reserves.

How do lenders calculate how much I can borrow?

Lenders use Debt Service Coverage Ratio (DSCR) to determine what your business could reasonably repay. Most lenders look for a DSCR of at least 1.25. DSCR is determined by the following formula:

DSCR = Net Operating Income / Total Annual Debt Service

For example, if a business generates $150,000 in net operating income and its existing debt payments total $80,000 per year, its DSCR is 1.875, which is above the 1.25 threshold most lenders require. A lender would then calculate the maximum additional debt payment you could sustain while maintaining a 1.25 DSCR or greater. In this case, the business would be able to manage up to $120,000 in total debt payments annually, or an additional $40,000 in annual debt service payments, while maintaining a 1.25 DSCR.

Even if you do qualify for the maximum amount a lender offers, it doesn’t necessarily mean you should take it. A good rule is to borrow the least amount required to achieve a specific purpose, and always with a clear repayment plan supported by existing revenue and cash reserves.

How much should I borrow?

Total business debt should not exceed more than three times your EBITDA (earnings before interest, taxes, depreciation and amortization). That means if your EBITDA is $100,000 per year, you shouldn’t carry more than $300,000 in total debt.

Total debt doesn’t paint the whole picture, though — you need to consider your debt service, or the repayment amounts due on your total debt each month. Your debt-to-income ratio should not exceed 36 percent. For example, if your business has an average gross monthly revenue of $10,000, you should be spending no more than $3,600 on debt service.

Of course, there are exceptions to this rule. You may consider exceeding this limit if you believe you have a clear opportunity to grow revenue and need investment capital to do it. However, it is important to always have a clear repayment plan that’s grounded in existing revenue; avoid factoring in expected future revenue into your debt service budget in case it doesn’t materialize.

How should you manage your business debt?

If your business debt no longer benefits your company and is starting to hurt you, here are four steps you can take to manage it.

1. Take a close look at your debt.

If you’re tracking your business finances through an Excel spreadsheet, you may not be aware of how much debt your business is carrying. To make matters worse, if you don’t have a full picture of your business finances, you can’t come up with a plan to manage it successfully.

Consider using small business accounting software, which allows you to get a complete picture of your company’s assets and liabilities. These platforms can automate expense categories, helping you identify where your money is going. This will help you develop a workable plan for paying down your debt.

>> Learn More About Accounting Software in Our Xero Review

2. Prioritize your business debt.

Not all debt is equal and some types are more problematic than others. For instance, high-interest credit card debt should be dealt with before paying off a small business loan with a low interest rate.

Ask yourself what would happen if you didn’t pay a particular debt right away and make decisions about prioritizing your debts based on the seriousness of the consequences. The more unpleasant the result, the higher priority paying off the debt should be.

Most often, meeting payroll obligations takes priority since you need to pay your employees to retain them and continue running your business. Before making payments to suppliers, vendors and creditors, focus on clearing your payroll liabilities.

3. Renegotiate your terms on bank loans.

One option for managing debt related to business loans is to approach your bank (or other loan provider) and attempt to renegotiate your loan repayment terms and conditions. If you’re a long-time customer, the lender may be willing to work with you to lower your interest rate or monthly payments. Even if an interest rate reduction isn’t possible, lenders might agree to extend the loan term to lower your monthly payment.

4. Talk about an alternative payment plan.

If you’re having trouble paying off your monthly loan installments or other debts, speak to your creditors before they come to you and ask for money. If you can come up with an alternative payment plan and show them how you would maintain your payments, your creditors may be more willing to work with you. After all, if you default on the debt, they won’t receive any money from you.

>> FREE TOOL: Debt Payoff Calculator

Should you refinance your small business debt?

If none of the previous steps are an option or give you enough breathing room, consider business debt consolidation, otherwise known as refinancing. Here are some reasons to consider this path.

Refinancing makes life simpler.

If you’re tired of juggling multiple due dates, bills and interest rates, refinancing can make your life easier. Refinancing will provide you with a single loan, so you’ll have one debt payment to keep track of instead of several.

“If your business is making multiple monthly payments on business credit cards, equipment financing and working capital loans, your life as a business owner could be simplified by consolidating those into one financing option and one debt payment,” said Ben Johnston, chief operating officer of Kapitus.

Refinancing saves your dollars.

Saving money is one of the biggest reasons to refinance. For instance, if your credit score has improved since you took out the original loan, you might qualify for better terms. You can switch to a lower interest rate, which will cut down on your monthly payments.

Johnston cited high interest rates as a top reason to consolidate your debts into a more affordable business line of credit or loan. However, there may be strings attached. “You may be required to offer a personal guarantee or some other form of collateral,” he told us.

Refinancing helps grow your business.

You can increase cash flow by refinancing your short-term debt into a long-term loan. Then you’ll have more capital available every month and you can concentrate on the expenses that matter most.

Refinancing boosts your credit score.

Combining your debt into a single payment could improve your business credit score. Whenever you refinance a commercial loan, you might see a sudden jump in your credit score since it reduces your credit utilization ratio.

Why is debt good for business?

Debt comes with many negative connotations, but as mentioned above, business debt isn’t always a bad thing. When used responsibly, it can help your business in the long run. Here are a few reasons why debt can be good for businesses:

• Lower financing costs: Debt requires lower financing costs when compared to equity. And unlike equity, debt is finite. This means you are required to make periodic payments for a specified amount of time until the debt is repaid — not forever.
• Optimizes the effects of financial leverage: Debt can also be beneficial because it allows you to maximize the effects of financial leverage. When a company owner uses debt as a method of securing additional capital, equity owners can keep the extra profits generated by the debt capital.
• Tax savings: Another benefit of using debt for business is that it helps with tax savings. Debt makes it possible to lower your company’s taxes because tax rules allow you to use interest payments as expense deductions against revenues.

When is debt a bad idea?

Here are a few reasons you may not want to take on business debt:

• Repayment issues: When you take on business debt, it has to be repaid in full with interest. If you don’t follow through on your repayment terms, you could damage your credit and business relationships.
• High interest rates: Certain types of debt come with hefty interest rates. If you don’t stay on top of your monthly payments, the amount of interest you owe can quickly balloon out of control.
• Credit rating: If you take on too much debt in a short period of time, it can impact your credit rating negatively since it signals your business may be overextended financially.
• Cash flow: Too much debt can adversely affect your cash flow. That’s because lenders typically expect the debt to be repaid in equal installments regardless of your income.

Mike Berner contributed to the reporting and writing in this article. Source interviews were conducted for a previous version of this article.