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Small business loans can be used to help grow your business, to cover costs during tough economic times, or to get your business through a slow season. Knowing how to apply for a business loan is crucial in order to increase your chances of approval and speed up your funding time.

This step-by-step guide on how to apply for a small business loan spells out reasons why you may need a business loan, the different types of loans and lenders, standard application requirements, tips for getting a small business loan, and more.

What to Know Before Applying for a Small Business Loan

When you’re looking for funding for your small business, there are many factors to consider as you search for the option that will work best for you. The type of funding, the loan repayment term, the interest rate, and other characteristics of the loan are important. But it’s also key to understand how you can impact your options through your actions – such as securing a loan or maintaining a good credit profile.

Secured vs. Unsecured Small Business Loans

Many kinds of business loans can be either secured or unsecured. If a loan is secured, it means that the borrower has put up some kind of collateral – real estate, cash assets, other valuables – that the lender would be allowed to claim if the borrower defaulted on the loan. This makes the loan less risky for the lender and consequently can result in larger loans and more favorable loan terms. Certain kinds of funding, like equipment financing, may be secured by the business equipment that the borrower is buying.

Unsecured loans, by way of contrast, do not require collateral. They often tend to be smaller and may come with less favorable terms. However, with an unsecured loan, the borrower doesn’t run the risk of losing any collateral.

How Your Credit Profile Impacts Loan Options

When you’re applying for small business funding, lenders will typically look at your credit profile to assess how creditworthy your business appears to be and how likely they are to be repaid for any funding they offer. In many cases, the kind of loan you’re eligible for depends, in part, upon your credit score. And if you are offered funding, your credit score may still influence the rates and terms of the loan, with high scores likely to get better terms.

Step 1. Determine Why You Need a Small Business Loan

Small business owners may need funding for a variety of reasons, and many of them depend on which stage you’re in. These needs can include:

•   Upfront costs

•   Expanding a business

•   Managing cash flow

•   Purchasing property

•   Buying equipment or inventory

Here’s a deeper dive into these reasons.

Upfront Business Costs

As much as you may want to jump in and get your business off the ground, doing some research and planning to estimate how much funding you need can potentially help you avoid headaches in the long run.

When you’re just beginning, you’ll need to think about startup costs, including:

•   Rent, utilities, and property repairs

•   Inventory

•   Equipment

•   Marketing

•   Insurance

•   Payroll

•   Permits

•   Legal fees

Expanding Your Business

Expanding a business is no small feat, and even profitable businesses may benefit from getting a small business loan. By using a loan to fund expansion, you can secure capital without jeopardizing your business’s current cash flow, helping ensure your transition from a small to midsize business is a smooth one.

Managing Cash Flow

Many businesses deal with fluctuations in cash flow due to seasonality, the economy, world events, and other factors.

Because it can be difficult to predict and financially prepare for such fluctuations, certain types of small business loans may help offset the gaps in cash flow.

Purchasing Property

Purchasing property typically requires significant financing in the form of a long-term business loan, like a commercial real estate loan.

Buying Equipment and Inventory

All businesses have equipment and inventory needs. Whether it’s buying, replacing, or repairing materials, you’ll need to know how to apply for business loans. Typical loans include equipment financing and inventory financing.

Refinancing or Consolidating Business Debt

Your business may already be paying off debt or debts that you incurred in the past. If you could now get a better interest rate – either because rates have dropped or your credit profile has improved – it may make sense to refinance to a lower-interest loan. If you have multiple loans, this strategy is called consolidation, and can simplify your payments as well as (ideally) reducing what you pay in interest.

Recommended: Improving Business Loan Chances

Step 2. Review the Business Loan Requirements

While there isn’t a one-size-fits-all formula for business loan requirements, lenders typically base their decisions regarding approval, rates, and terms on how risky they think it would be to lend to your business.

Lenders usually assess risk using a variety of factors, including:

•   Credit scores

•   Business age

•   Revenue history

•   Debt-to-income ratio

•   Cash flow

Remember that individual lenders may have their own small business loan qualifications, so compare carefully.

Lenders Want to Know Your Credit History and Score

When you apply for a small business loan, lenders often want to look at your personal and business credit scores. If your business is new, lenders may primarily rely on your personal credit score to determine eligibility.

When you have a high credit rating, lenders may see you as a trustworthy borrower and worth the risk of lending to at more favorable rates.

Generally, traditional lenders like banks and credit unions want to see credit scores over 620-640 to consider you for a small business loan. But some lenders do offer loans to businesses with challenged credit.

Building Business Credit

A well-established business credit history can potentially help you get better business loan rates and terms.

To establish or build business credit:

•   Separate your business from your personal finances by getting an Employer Identification Number (EIN) and maintaining a business bank account that is separate from your personal account.

•   Open a business credit card or business line of credit and make payments on time.

•   Work with vendors and suppliers who report to business credit bureaus.

•   Check your personal and business credit reports.

Is Your Business Established?

Frequently, lenders see new businesses as riskier, so it may be challenging to secure a first-time business loan. If you have other sources of startup funding, consider them before applying for a small business loan.

Small business lenders typically prefer businesses that have been established for at least two years. While there are startup business loans, your options may be relatively limited.

Recommended; What Is a Startup?

Revenue History Matters

Lenders want to know how much revenue your business brings in to gauge whether you’ll be able to repay your loan. They may even have a minimum revenue requirement for small business loan applicants.

Knowing your minimum annual revenue can help determine if a lender is a good fit for your business.

Knowing Your Debt-to-Income Ratio (DTI)

Lenders may assess your debt-to-income ratio (DTI) as part of your small business loan application to make sure you can pay back the loan.

To calculate your business’s DTI, divide your monthly expenses by your gross monthly income. Then, multiply that number by 100 and add a percentage sign to see your DTI.

Debt-to-Income Ratio (DTI) = Total Monthly Expenses ÷ Gross Monthly Income x 100

Generally, if your DTI is high, it may be harder to qualify for a small business loan because having more debt than income can seem risky to potential lenders.

Is Your Cash Flow Sufficient?

Assess whether you’ll have the cash flow to pay back the loan. Lenders may use several pieces of information to calculate your cash flow when determining if you meet their small business loan requirements.

Collateral and Personal Guarantee Requirements

In some cases, lenders may ask you to provide collateral or a personal guarantee to help reduce their risk. Collateral is something of value – such as a vehicle, real estate, or financial assets – that you agree the lender can claim if you default on your loan. A personal guarantee is a legal agreement that if your business can’t pay back the loan, you personally will be legally and financially responsible for it.

Note that while both these options may make it possible for you to get a loan and/or receive better terms, they put you at risk of losing your collateral or other assets if your business defaults on the loan.

Recommended: Guide to Business Loan Brokers

Step 3. Calculate the Amount of Capital Needed

Creating an adequate business capital estimate can reduce stress and avoid the need to apply for another small business loan down the road. Knowing your needs will help you figure out your chances of obtaining a loan and estimating how much of a business loan you can get.

Start by determining if your expenses are:

•   One-time purchases or ongoing: One-time major purchases can disrupt cash flow. Ongoing expenses happen monthly, quarterly, or annually and don’t change much.

•   Essential or optional: Can the business operate without this purchase? If not, it’s essential. If so, it’s optional. Essential expenses are typically prioritized over optional ones.

•   Fixed expenses: Fixed expenses don’t change significantly or often. These may include rent, insurance, or regular business expenses. Consider what your business loan may need to cover and adjust your desired amount accordingly.

Estimating Cash Flow

Project your cash flow for at least a few months out. Will you have enough to keep the business running and make loan payments? If not, applying for a business loan may need to wait.

You can use the following formula to help calculate your future cash flow:

Cash Flow Forecast = Starting Cash + Projected Inflows − Projected Outflows

Projected inflows include sales, investments, income, etc. Projected outflows include wages, rent, inventory costs, etc.

Factoring in Interest, Fees, and Repayment Terms

You’ll also want to consider the cost of your funding. That means taking into account the total interest you will be paying. If your interest rate is fixed, this is potentially easier to calculate than if it’s variable.

Your repayment term will also play into the total interest cost – if your term is longer, you’ll typically pay more in interest over the life of the loan, though your monthly payments will probably be lower.

Finally, you’ll want to look at both any required fees and the fees you might incur if you want to pay your loan off early or if you make a late payment. Reading your contract can help you understand these potential costs so you can make an informed decision.

Recommended: 15 Types of Business Loans to Consider

Step 4. Explore Small Business Loan Options

Once you’ve gathered all the relevant information, you’re ready to start comparing loan options. You can do this on your own or you can work with a business loan broker.

Below are the different types of business loans and why you might want to choose one over another.

Small Business Administration (SBA) Loans

SBA loans are backed by the U.S. Small Business Administration, so they pose less of a risk to lenders. Loans guaranteed by the SBA offer relatively favorable rates and terms.

Many SBA loan programs suit the small business owners’ unique needs, but the most popular program is the SBA 7(a). These loans can be useful for qualified small businesses needing up to $5 million for almost any business-related expense.

Additional options include an SBA 7(a) Small loan for up to $350,000, an SBA Express loan with a turnaround of 36 hours, and an SBA 504 loan, which is used to purchase commercial real estate.

Why Choose an SBA Loan?

SBA loans are geared toward a variety of small business applicants, including startups, veterans, women, and underserved communities.

They can be used to finance large, one-time purchases or smaller, ongoing expenses, allowing your company to grow and build business credit.

Things to Keep in Mind About SBA Loans

Since SBA loans are backed by the U.S. government, the qualification and application process can be longer and more complicated than a traditional bank or online loan.

If you need funding quickly, lack a well-established business, or have poor business credit, you may want to consider a non-SBA-backed loan.

Term Loans

Small business term loans let you borrow a set amount of money that you pay back with interest on a predetermined schedule. Lenders determine rates and terms based on your creditworthiness.

Both long- and short-term loans are available for small businesses. The type you choose to apply for depends on your company’s needs.

Why Choose Term Loans?

Term loans can be useful for large, one-time purchases because they allow you to repay over time, posing less risk to your business’s cash flow. With long- and short-term options, you can decide what makes the most sense for you.

Long-term small business loans typically have lower interest rates for qualified small business loan applicants. However, extending the loan could lead to considerable accrued interest over the life of the loan.

A short-term loan may have higher interest rates, and businesses generally turn to them when they cannot qualify for another loan or line of credit.

Things to Keep in Mind About Term Loans

While you can find term loans from several types of lenders, banks and credit unions may have lower interest rates. However, they may also have more stringent business loan application eligibility requirements.

Using a small business loan calculator can help you assess and compare different loans and how much they will cost you, monthly and in the long run.

Business Line of Credit

A business line of credit can be revolving or non-revolving and grant access to funding up to your credit maximum. Interest is only charged on unpaid balances from previous billing cycles.

With a revolving line of credit, you can withdraw and repay as needed but can’t spend over the approved credit limit. Non-revolving lines of credit end after you’ve paid the balance in full.

Why Choose a Business Line of Credit?

If you need to manage cash flow during seasonal fluctuations or have unexpected expenses, a business line of credit can provide quick funding without the commitment of a small business loan.

Things to Keep in Mind About Business Lines of Credit

A business line of credit can be a relatively affordable option for shorter-term needs in some cases, but not always. It’s important to take note of the interest rate, since rates range from about 7.00% to as much as 60.00%.

If you aren’t sure whether you’ll be able to pay the monthly balance on a line of credit, it may be worth exploring other financing options.

Recommended: Small Business Loan vs. Line of Credit

Microloans

Microloans are typically offered by nonprofit organizations and peer-to-peer lenders in amounts up to $50,000. Applying for these small business loans often has a personal aspect other lenders may lack.

Why Choose a Microloan?

Microloans are used for businesses needing relatively small amounts of financing. Mission-based lenders can be one option when searching for microloans because they may offer specialty funding for minorities and underserved communities.

SBA microloans are also available and may offer more competitive interest rates than other lenders.

Things to Keep in Mind About Microloans

Generally, eligibility requirements for business microloans aren’t as strict as they are for term loans.

Check with lenders to confirm interest rates so you can accurately estimate how much a microloan may end up costing.

Equipment Financing

Equipment financing is funding for purchasing business-related equipment, like machinery or vehicles, where the equipment acts as collateral.

Both small business startups and established businesses may benefit from equipment loans to keep business operations running smoothly.

Why Choose Equipment Financing?

If your business needs new equipment but doesn’t have the savings to purchase it, equipment loans may offer favorable interest rates. There are also leasing options if you anticipate regularly replacing or upgrading equipment.

Things to Keep in Mind About Equipment Financing

Generally, the equipment acts as collateral for equipment financing. This type of financing can also be limiting, as you can only use the funds for business-related equipment.

Invoice Factoring and Financing

With invoice financing, lenders use your business’s unpaid invoices as collateral for a cash advance. You are responsible for collecting unpaid invoices from clients and repaying the lender once you receive payment.

With invoice factoring, a lender purchases unpaid invoices from you, then collects payment directly from your clients.

Why Choose Invoice Factoring and Financing?

Business-to-business (B2B) organizations with irregular billing cycles can use invoice financing or factoring to cover operating expenses without waiting for clients to pay.

Lenders advance you a percentage of the outstanding invoice amounts, which you can use to reinvest in your business or pay your bills.

Things to Keep in Mind About Invoice Factoring and Financing

Business-to-consumer (B2C) organizations that don’t invoice customers regularly will likely be ineligible for invoice factoring or financing.

Additionally, because the lender takes on more risk with invoice factoring, the terms may not be as favorable as those for invoice financing.

However, if you choose invoice financing, you are responsible for collecting payments from customers and paying the lender. If customers are late, any late fees from the lender fall to you.

Lenders may also charge non-refundable processing and repayment fees for invoice financing and factoring. Check with your lender about additional fees so you can budget accurately.

Commercial Real Estate Loans

Getting a business loan for commercial real estate allows you to purchase a building for business use. These loans can be in the millions and typically offer competitive interest rates because they’re backed with the real estate you’re purchasing.

Why Choose Commercial Real Estate Loans?

If you need to acquire a business property, a commercial real estate loan may be your only option for financing. Because commercial real estate can be pricey, paying for it without getting a business loan could strain your company’s finances and cash flow.

Things to Keep in Mind About Commercial Real Estate Loans

Commercial real estate loan approval and structure typically factor in the loan-to-value (LTV) ratio: the size of the loan divided by the value of the property, expressed as a percentage.

Loan-to-Value Ratio (LTV) = Loan Amount ÷ Commercial Property Value

Usually, the lower the LTV, the better the rates and terms you’ll receive on the loan. Most commercial real estate loans have LTVs between 65% and 80%.

Commercial real estate loans may carry additional costs for things like appraisal, inspection, and filing fees. Ask your lender about expenses to gauge whether a commercial real estate loan is the right choice for you.

Recommended: Guide to Small Business Financing

Step 5. Compare Small Business Loan Lenders

Banks, credit unions, online lenders, and peer-to-peer networks all offer loans for small businesses.

Online Lenders

Online lending can be helpful for small businesses that are just starting out or need funding quickly. Applying for a business loan online may offer several advantages, including:

•   Fast application review

•   Quick access to funds

•   Can be easier to qualify for with little business credit history

•   Easy to compare different lenders

•   Options for unsecured loans

However, online lenders typically can’t beat the APRs from banks and credit unions.

Traditional Banks

Banks can offer term loans, lines of credit, equipment loans, and credit cards. Some banks partner with the SBA and offer government-backed loans for approved borrowers, including 7(a) programs.

Additionally, interest rates and terms may be more favorable with a bank than with other types of lenders. But applying for a business loan with a bank typically takes more time than applying with an online lender.

Small businesses may find it challenging to get approved for a business loan from a bank because banks may require good credit, collateral, and an established business history. Funding may also take longer to get because of the more rigorous application and approval process.

Peer-to-Peer (P2P) Lending Networks

Peer-to-peer (P2P) lenders match small business loan applicants directly with investors (not financial institutions). As a result, this option may be attractive to small businesses struggling to get financing elsewhere.

Deciding factors may include credit scores and social media profiles — anything that helps each party determine if they want to partner. P2P business loan requirements vary greatly as a result.

P2P marketplaces set the terms and rates for the loans, and these can vary depending on the borrower’s creditworthiness. They also help facilitate money transfers and payments.

As you’re researching your options, investigate transaction fees charged by different P2P marketplaces, as these could fall to you, the investor, or both.

Credit Union

Credit unions are similar to banks but are member-owned and not-for-profit. As a result, profits are typically returned to members in benefits such as reduced fees, more competitive loan interest rates, or higher rates on savings accounts.

Many people choose to apply for business loans from credit unions because they offer competitive interest rates and terms, and they may have more flexible qualification standards. They also tend to be community-oriented, which may benefit small businesses wanting to invest in the areas where they live.

Step 6. Prepare Your Documents and Apply for a Loan

The final step is gathering the necessary documentation for your small business loan application(s).

Documents you need to provide vary by loan and lender. That said, here are a few items lenders typically require:

•   Business and personal bank statements

•   Business and personal tax returns

•   Business legal documents

•   Personal identification and resume

•   Business plan

•   Revenue statements

•   Accounts receivable and payable

How you’ll apply for a business loan depends on the lender. An online lender may permit you to link your business accounts through its website. For a bank or credit union, you’ll likely apply in person at the branch (if they have brick-and-mortar locations) or via a phone call.

What to Expect After Applying

Once you’ve applied, you’ll wait to see if you’re approved. Some lenders approve borrowers almost instantly, whereas others may take a few business days. If the lender requests additional documentation, be sure to respond quickly to prevent delaying the process. Once approved, funds typically will be in your account within one day to one week.

What Happens When You Get Your Loan

You’ll be notified when the loan is approved and told the next steps in the process. For example, after an SBA loan is approved, you can expect to receive the funds in the designated bank account after five to seven business days.

Important Factors to Consider

When planning your business borrowing, it’s important to consider what type of loan is most appropriate for your situation. Different loans cater to specific needs, such as working capital, equipment purchase, or startup costs. If your credit is strong, you should have access to more loan options and a lower rate.

Before applying, assess how much money your business needs to achieve a specific aim. Estimate how big a payment you’ll be able to make each month, given your business’s cash flow. That could help determine the term of your loan.

You also may need to back your loan with collateral or a personal guarantee. If your credit score is on the low side, you may need to put up additional collateral to get approved.

Tips for Improving Your Loan Approval Chances

To increase your chances of loan approval, here are some simple things you can do:

•   Put up collateral. This can lower the risk for the lender.

•   Pay down your existing debts. A lower DTI may help persuade the lender that you’ll be able to manage additional loan payments.

•   Find ways to strengthen your personal and business credit. If you can pay off some debt, that should be a good start. Consistently making timely payments on all your bills may also help.

•   Choose the right lender. Not all lenders have the same requirements. If your business credit score is low, for example, you will likely have a better chance of loan approval with an alternative, online lender than with a traditional bank.

•   Wait a year or so if you can. Lenders typically like to see more than a year’s worth of business history. If you direct your efforts into building a strong foundation for your business and increasing your revenue, you’ll likely have a better shot at loan approval in the future.

The Takeaway

If you’ve been wondering about how to apply for a small business loan, you’ll first need to determine what it is you want a business loan for. Knowing this will help you choose the right type of small business loan for your situation.

Once you’ve decided on a loan type, it’s important to understand how to qualify for that small business loan, so review the loan requirements, gather the necessary documentation, and research and compare lenders. Shopping around for lenders allows you to find the best rate and terms possible for your particular small business.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

Is it hard to get approved for a small business loan?

There are many different types of small business loans you may qualify for, even if you have bad credit or are a brand-new business. However, in order for you to qualify for the best rates, lenders will want to see good to excellent credit, stable business income, and at least six months of business history.

Can I get a loan for a first-time business?

Yes, startups can qualify for small business loans. Qualifications will vary by lender, but most will want to see good credit scores and an in-depth business plan. You also may need to back your loan with collateral or a personal guarantee.

What credit score do you need for an SBA loan?

The minimum credit score needed for an SBA loan is typically between 620 and 640, but may be higher, depending on the loan type and the lender. If you don’t meet the requirement, you may want to consider other types of business loans, including term loans, a business line of credit, or equipment financing.

What documents do I need to apply for a small business loan?

Each lender will have its own specific requirements, but among the commonly requested documents are: business and personal bank statements, business and personal tax returns, business legal documents, personal identification and resume, business plan, revenue statements, and accounts receivable and payable.

How long does it take to get approved for a small business loan?

The time it takes for your loan to be approved depends on the lender and the type of loan you’ve applied for. Online lenders or alternative financing platforms often offer streamlined applications and quick approval processes, sometimes within 24 to 48 hours. The standard SBA 7(a) loan is turned around in five to 10 business days.

Photo credit: iStock/JLco – Julia Amaral

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A business’s debt service coverage ratio (DSCR) is a convenient, concise way to express the company’s level of financial stability. The ratio compares the business’s annual net operating income (NOI) to its total debt payments for the year.

Specifically, a company’s yearly DSCR divides its NOI (revenue minus operating expenses) by its total debt outlay (payments toward principal and interest). Lenders often use this figure to assess real estate loan applications.

Read on for more details about this essential indicator of financial fitness.

Why DSCR Matters for Businesses and Borrowers

Any business needs to earn enough to pay its expenses. The DSCR shows how easily the company can cover its current debt costs.

An owner might track their company’s DSCR to monitor their ability to take on additional small business loans. Or they might commit to keeping their company’s debt coverage ratio above a certain level to ease its dealings with lenders.

Lenders care about DSCR because it indicates whether a company has enough income to pay its debts. A company with a high ratio generally has stronger finances and thus less risk of default. Banks and other lenders are more likely to extend favorable loan terms and lower interest rates to a business with an ample financial cushion.

By the same token, a business with a low DSCR could end up paying higher interest on loans. The additional charge would be a lender’s equivalent of hazard pay, compensating the bank for its extra risk.

Commercial real estate lenders regularly consider DSCR when assessing loan applications. They want to be sure that the property being purchased can earn enough net income (through rents, for example) to pay its mortgage.

How DSCR Works

As noted above, the debt service coverage ratio expresses the business’s ability to service (that is, pay) its debt obligations.

One part of the ratio is the business’s annual net operating income (NOI) — that is, all the money brought in by the business, minus the cost of running it. The second part of the ratio is the business’s total debt payments for the year.

To calculate the ratio, you’d divide the former amount by the latter amount. The debt service coverage ratio formula is:

A business with a DSCR greater than 1 earns enough net income to service its debts. For example, a DSCR of 1.25 means that a business has an NOI of $1.25 for every $1 of debt service, leaving a 25% surplus. The higher the DSCR, the bigger the company’s financial buffer.

By the same token, a DSCR below 1 indicates the company isn’t generating enough cash to cover its debt payments, signaling potential default risk. The business needs to increase income, reduce debt, or both.

DSCR Formula and How To Calculate It

To review, the debt service coverage ratio formula is:

The two amounts needed for the DSCR formula are:

•   NOI = Total revenue minus operating expenses. Yearly operating expenses typically include property taxes, insurance, service fees, and other costs.

•   Total debt service = The annual sum of all principal and interest payments due

It’s important to note that NOI is similar to EBITDA (earnings before interest, tax, depreciation, and amortization), though not the same. Nor is NOI simply equal to revenue.

Like NOI, EBITDA shows a company’s profitability based on its core business operations. But NOI is generally used in real estate to evaluate income-producing properties, so it is less universal than EBITDA, which is most often used to measure how efficiently a company is operating overall and how it compares to competitors.

It can also be useful to compare revenue vs. EBITDA. The main difference is that revenue measures sales activity, while EBITDA measures how profitable the business is. Revenue is calculated by adding up income from all business operations, whereas EBITDA takes that revenue and then subtracts expenses in order to measure profit.

To find out your business’s DSCR, you can run the numbers with our Debt Service Coverage Ratio Calculator.

DSCR Calculation Example

To compute your business’s DSCR on the SoFi calculator, you’ll need to have certain figures at hand. As you can see on the calculator, these include:

Annual Income (Cash Flow)

•   Your business’s annual NOI

•   The depreciation and amortization amounts that were deducted on the business’s most recent tax return. This information is recorded on IRS Form 4562, Depreciation and Amortization, which you would have filed with the other forms in the return.

•   Any other capital contributions or non-operating income infusions to the business. One caution: Because these cash injections probably don’t occur every year, you can’t necessarily assume they’ll be part of your annual DSCR in the future.

Annual Debt Service

•   The total you pay each year in both principal and interest on your business loans and mortgages

•   The annual total of your lease payments for property and equipment

•   Principal and interest payments for any other debts on your books

The DSCR is a ratio, which means it can be calculated as a fraction.

To get the fraction’s numerator, the calculator will add up the figures listed under the heading Annual Income (Cash Flow). For the denominator, it will total all items listed under the heading Annual Debt Service.

Here’s an example to show how all of that comes together when you’re calculating the DSCR. Imagine your business records show the following:

In this case, we’d divide the income subtotal by the debt subtotal:

Lenders generally consider a ratio of 1.25 or higher to be healthy.

What Is a Good DSCR?

Having a healthy DSCR assures banks and other lenders that your business can handle its debt obligations. Banks typically want to see a DSCR above 1, signifying that the company has more than enough working capital to pay its loans — but beyond that, there’s no single, universal benchmark. Different industries may have different standards for debt coverage ratios.

For instance, service industries (e.g., restaurants and breweries) may operate with lower DSCRs to allow for seasonal fluctuations. Professional firms, such as accounting or legal practices, can often have ratios on the higher side because their cash flow tends to be steadier, as it may come from retainers, subscriptions, and other recurrent charges.

That said, a DSCR of at least 1.25 tells lenders that the company can handle unexpected costs without falling behind on its debt payments. For SBA 7(a) loans, the desired DSCR is 1.15 or more.

Recommended: Small Business Credit Cards

Why a Good DSCR Can Vary by Lender

In general, as discussed above, lenders prefer a higher DSCR because it signals less risk.

But just how high the DSCR needs to be is up to the lender to decide. Some banks can accept a higher level of risk and will lend to a company with a lower DSCR, where NOI barely outpaces debt service payments. Other, more conservative lenders will want an applicant to have a higher DSCR so that business setbacks are less likely to jeopardize the loan.

The specifics of a loan application affect the lender’s analysis, too. If a business’s sector, financial situation, or location are less stable, banks may expect higher ratios (say, 1.25 or more). A more predictable business with a lower DSCR may be able to get a loan due to the steadiness of its revenue.

Some other factors that could come into play are:

•   Property type, if the business is purchasing real estate

•   Type of loan program, such as a traditional mortgage vs. a non-qualified mortgage

•   NOI specifics, as the lender may consider different income projections or additional operating expenses

Small business owners may also be asked for a global DSCR. This calculation is based on the owner’s personal income and personal debts, rather than those of the small business. Such information can be relevant when, say, a company applies for a startup business loan. A global DSCR could be additional evidence of financial responsibility and timely repayment of debt.

What Impacts DSCR?

As noted, some factors that could affect a business’s DSCR are:

•   Its total revenues

•   Its total operating expenses

•   Which costs are included in operating expenses

•   The cost (amount and interest rate) of the company’s current debt

Beyond the company’s financial specifics, overall economic conditions can also have an impact. A company’s DSCR might change noticeably depending on how the local or national economy is doing. Flush times could boost profits, increasing the DSCR. A downturn that reduces income might lead to a decrease in the DSCR.

How To Improve DSCR

In general, if your business cuts its costs and increases its revenue, you can expect its DSCR to improve. Increasing revenue might mean raising prices or offering additional services to customers. Cutting costs can be trickier. Here are three approaches that could help:

•   Shrink operating expenses: Comb through your balance sheet and business checking records for ways to spend less. For example, negotiating volume discounts from vendors or flat-fee service contracts could bring down operating costs. Installing energy-efficient systems (e.g., smart thermostats) might save you money on the company’s power bill, lowering NOI. Changes in your spending levels could take effect within a month or so, depending on what actions you take.

•   Explore refinancing your debt: If you can, look into lowering your debt payments through refinancing. This may involve extending the loan term or renegotiating for a lower interest rate. How soon this change could materialize depends on the success and speed of the refi process.

•   Maximize tax benefits: There may be IRS or state provisions that could lower your taxes, thereby increasing your net operating income. This change could happen as soon as your next tax filing, if your company meets the requirements.

DSCR Mistakes To Avoid

When you’re calculating DSCR, mistakes can happen. One narrow example might be including revenue from isolated incidents (such as, say, an asset sale) in making your projections. Inaccurate cash flow estimates are likely to distort your NOI figure, so double-check that you’ve got all the correct numbers for the calculation.

Bigger DSCR errors can come from viewing your business situation too optimistically. This might mean overestimating projected NOI, underestimating expenses, or disregarding unfavorable market trends.

Exaggerating revenue estimates can lead to long-term financial problems. You may want to factor in extra cash reserves for unexpected costs or delays. To figure out how much you might need, you can stress-test your DSCR. Evaluate how well your business can sustain its debt service under different economic scenarios, such as a rise in interest rates.

Overall, your best bet for avoiding serious DSCR mistakes is to keep your income projections realistic and factor in all applicable expenses.

Recommended: Business Line of Credit

The Takeaway

The debt service coverage ratio, known as DSCR, compares a business’s annual net operating income (NOI) to its total yearly debt payments. A DSCR greater than 1 means the business can cover its debt obligations, but lenders typically prefer a ratio of 1.25 or more, indicating an ample financial cushion. To improve its DSCR, a business could increase its NOI — by reducing operating expenses, say, or maximizing tax benefits — or reduce its debt service payments through refinancing.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

What is the debt service coverage ratio (DSCR)?

The DSCR is a comparison that indicates a company’s ability to make its loan payments. It’s calculated by dividing the annual NOI — which is revenue minus operating expenses — by the total debt outlay (that is, payments toward principal and interest). Expressed as a formula, DSCR looks like this:

How do I calculate DSCR?

To calculate DSCR, divide the company’s annual net operating income (NOI) by its total debt payment for the year. If the two numbers match, the result equals 1. That means the business’s net income is just enough to service its debt.

A DSCR greater than 1 means the business earns more than it needs to pay out for its debt, signifying a lower risk of the company defaulting on its loans. A DSCR less than 1 shows that the business’s NOI is not enough to pay its loans, suggesting a higher risk of default.

What affects DSCR the most?

Many factors can impact a company’s DSCR. Arguably the most significant one would be the NOI, since that figure encompasses both revenue and expenses. As a result, the NOI is vulnerable to a wider set of potential problems. A change in NOI — declining revenue after losing a client, say, or rising expenses due to higher electricity costs — is likely to alter the ratio.

How can I improve my DSCR quickly?

Cost-cutting is likely to be the fastest way to improve your ratio. Three possible ways to do that are shrinking operating expenses, refinancing debt, and maximizing tax benefits.

Photo credit: iStock/Jacob Wackerhausen

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

SOSMB-Q425-095

With a revenue-based business loan, a financing company loans your business a lump sum of cash and, in return, you give it a certain percentage of your business’s future monthly revenues. In contrast to traditional business loans, your monthly payments for this kind of funding don’t stay the same, but instead rise and fall as your revenue rises and falls.

Small business loans based on revenue can be a good option for companies that have strong sales but aren’t able to qualify for other small business loan options. You’ll want to keep in mind, however, that this type of financing generally comes with higher costs than traditional business loans.

Read on to learn about how business funding based on revenue works, the pros and cons of business revenue financing, how to find revenue-based business loans, and more.

What Is a Revenue-Based Business Loan?

A revenue-based small business loan is a type of cash flow loan that allows you to borrow against future revenue.

A revenue-based loan provides you with a lump sum amount that’s based on your monthly or annual revenue. Then, instead of asking for fixed monthly payments (as with a typical small business loan), the financing company takes a defined percentage of your total sales within each repayment period, which may be one week or one month.

When reviewing your loan application, a revenue-based lender focuses primarily on your revenue stream and your business plan. Lenders look for the potential to increase your revenue, since the faster your business grows, the sooner the money is paid back and the lower the risk to the lender.

Key Features of Revenue-Based Business Loans

Revenue-based loans allow for greater flexibility than traditional loans. A revenue-based loan is similar to a merchant cash advance in that your repayment amounts fluctuate with your sales volume. With a merchant cash advance, however, repayments come only from debit and credit card sales. A revenue-based loan involves total receipts. This might mean you can afford higher payments and potentially borrow a larger sum.

Payment Flexibility

As mentioned above, small business funding based on revenue doesn’t call for fixed monthly payments. Instead, because repayment amounts are directly tied to your business’s revenue, your payments will be higher during strong sales months and lower during slower periods.

Revenue Thresholds and Repayment Terms

To be eligible for revenue-based financing, you generally have to show that your company’s sales exceed a certain amount per month or year. This is called the revenue threshold, and it will vary by lender. The lender wants to ensure that you’ll have enough coming in every month to make a satisfactory payment.

Typically, there is no set period in which you’re expected to pay back the entire loan, since the amount you’ll replay can vary from month to month based on your sales

Factor Rates and Total Repayment Caps

The cost of the loan comes from a multiplier or factor rate (such as 1.5x) that’s applied to the lump sum that you borrowed. If you take out a revenue-based loan for $10,000 with a 1.5x factor, you’d pay $15,000 in total. That’s likely to be costlier than a traditional loan with a longer term.

The repayment cap is the total amount you will pay back on the loan. It’s calculated by multiplying the principal by the factor rate. If you have strong sales for several months, you will likely reach the repayment cap sooner than if you have poor sales. But whenever you have paid back that amount, you will have fulfilled your obligation. Additionally, there may be a cap on how much money you can repay in a set period, regardless of your sales or the percentage.

How Revenue-Based Business Loans Compare to Traditional Business Loans

Revenue-based business loans vary in significant ways from other types of typical business funding. Some of the most significant include the qualifying criteria for the loan, the way the cost of the loan is determined, and the repayment structure. Let’s take a closer look.

Revenue-Based Financing vs. Term Loans

A common form of small business funding is a small business term loan. With these loans, you apply with a lender, typically providing information to establish your creditworthiness and ability to repay the loan – your annual revenue, your time in business, your personal and business credit scores, and so on. If you get a term loan, you receive a lump sum and then pay it back, with interest, over a specified period of time. In some cases, you may secure your loan with collateral.

In contrast, revenue-based financing typically requires less paperwork and faster approvals. As with a term loan, borrowers receive a lump sum and begin repayments. But instead of an interest rate, borrowers will pay a factor rate – typically this means the total cost of a revenue-based loan will be higher. And rather than a set amount each month, they’ll pay a percentage of their monthly revenue until they reach the total repayment cap. These loans generally don’t involve collateral.

Revenue-Based Financing vs. Merchant Cash Advances

A merchant cash advance (MCA) can appear more similar to a revenue-based business loan. This form of funding is typically faster than a traditional loan, and involves the borrower getting a lump sum upfront. There’s a factor rate, rather than interest, and the cost of the loan is typically higher than a traditional loan.

The major difference between the two types of funding is that a merchant cash advance takes a percentage of your business’s credit and debit card payments, sometimes as often as daily, as opposed to a percentage of gross revenue monthly. It’s also worth noting that MCAs are not considered loans – they are sales – and may be less subject to regulation than revenue-based business loans.

How Does Revenue-Based Financing Work?

With revenue-based business loans, the lender determines how much you can borrow based on your sales, as well as the payment frequency that would work best with your business. You may pay weekly or monthly depending on what the lender thinks you can handle.

Unlike other types of small business loans, revenue-based funding does not involve interest payments. Instead, the repayments are calculated using a particular multiplier that results in repayments that total higher than the initial investment. Typically, these loans come with a repayment amount of 1.1 to 2.5 times the principal loan.

Revenue-based loans are not bound by the same regulations as bank loans. As a result, approvals and funding can be obtained in a relatively short period — generally much shorter than the weeks or months it may take a bank to reach a decision on a traditional loan.

Once you agree to the loan terms, the lender will provide you with a lump sum of capital and soon after will begin deducting a percentage of your revenue. The percentage that is deducted in each payment period is known as the capture rate or the performance rate. It typically falls somewhere between 2.00% and 12.00% of your monthly gross revenue. Using this model, you should ideally never pay more than your business can handle.

Because your payment amount fluctuates with your total sales, payments can, theoretically, go on for a long time, potentially several years.

What Can Revenue-Based Business Loans Be Used for?

Lenders typically expect these loans to be used to develop new products, expand your sales force, or venture into new markets.

However, you can generally use the funds you receive through a revenue-based loan in any way you see fit to support your business. Often borrowers use the funds from a revenue loan in a way that will increase their sales and profit margins or to prepare for a busy season that’s on the horizon. Higher revenues mean you’ll generally pay off the loan faster.

How Can You Pay Off a Revenue-Based Business Loan?

Revenue-based loans are paid off over time, and the amount you pay each month depends on your total sales. Therefore, if you have a stellar few months in sales, it’s feasible you could pay off the loan during that busy season. However, if you have a few slow months, your payments won’t be that much and it will take longer to pay off the loan.

What Happens If Revenue Drops?

Since a revenue-based business loan is repaid through a percentage of your gross revenue, the amount you’ll pay each period (typically per month) will vary. That means that if your revenue drops during one or more months, you’ll pay the same percentage, but that will amount to less cash. If your revenue drops for a long period, it will take you longer to reach your total repayment cap and pay off your loan.

Recommended: Business Loan Calculator

Pros and Cons of Business Loans Based on Revenue

Like all loan products, revenue-based loans have both pros and cons. When comparing this type of funding to other small business loans, consider the following benefits and drawbacks.

Advantages

A key advantage of revenue-based business loans is that your lender looks at your revenue — and generally not at how old your business is, not at your collateral, and not at your personal or business credit score.

Even if you can’t qualify for a traditional business loan, you may be able to get a revenue-based loan.

For many business owners, it’s the repayment terms that make revenue-based loans particularly appealing. Term loans with fixed payments can work well if your business has consistent, reliable sales. But if your company goes through swings throughout the year, then a fixed monthly payment may not be ideal. With a revenue-based loan, your payments should reflect what you can actually afford to pay.

Unlike merchant cash advances, which only work if your customer base pays with either credit or debit cards, revenue-based loans can work for any business, regardless of how its customers pay. All that matters with revenue-based loans is your total monthly revenue.

Revenue-based financing also tends to carry longer terms than merchant cash advances. This is because the latter often requires a daily payment, while the former can be paid monthly or weekly.

Disadvantages

Revenue-based loans are often pursued by businesses that can’t qualify for traditional loans due to poor credit. From a lender’s perspective, poor credit increases the likelihood that you might not be able to pay off the loan on time. To mitigate this risk, revenue-based financing often comes with high rates and fees. This type of loan can even be more expensive than a merchant cash advance because of the higher borrowing amounts and longer terms.

Since your payment is tied to monthly revenue, your loan term fluctuates. While the faster you grow, the faster you pay off the loan, the opposite is also true — if your growth is slower than expected, the number of months needed to pay off the loan will grow.

Finally, you’re giving up a portion of your revenue each month. That means you’ll have less cash available for other things — like taking advantage of new opportunities that come up, or addressing the unexpected.

Ideal Candidates for Revenue-Based Business Loans

Revenue-based loans can align well with businesses that have fluctuating sales or those that don’t qualify for traditional financing. Also, time frames for these loans may be comparatively short, so companies that are well-positioned to repay their loans faster may also be a good fit.

Types of Businesses That Benefit

Seasonal businesses are compatible with revenue-based financing, as borrowers can make smaller payments during leaner times and larger ones when sales are strong. Examples might include Halloween costume shops and ski equipment dealers.

Businesses with recurring revenue streams, such as software-as-a-service companies and subscription-based enterprises, can also benefit from this form of funding.

Recommended: How to Price a Business

Is a Revenue-Based Loan Right for You?

If you don’t have the credit scores to get a traditional business loan but have solid revenue — and a plan to make it grow even higher — a revenue-based business loan may be a good option for you. These lenders generally care more about where your business is going than where it has been.

And If you use the loan proceeds to develop new products, increase your sales force, or develop new sales initiatives, the result will likely be increased revenue, which will allow you to pay off the loan sooner and could make the high cost of the loan worth it.

This might also be an appealing type of financing if you operate a seasonal business, since your payment will fluctuate along with your revenue and/or you need capital quickly, since it can be faster to get than a traditional loan.

However, you might not be the best candidate for this type of loan if you aren’t certain that your business will be experiencing a solid amount of growth. Also, if your business is struggling, the higher costs that come with this kind of financing could become problematic. In that case, you might want to look into other business loans for bad credit.

Questions to Ask Before Applying

If you’re considering applying for a revenue-based loan, determining the answers to these questions may help you decide.

•   Does your business have a track record of strong, reliable sales and/or plans for increasing them?

•   Would it be difficult for you to obtain other forms of financing that might be less expensive?

•   Are you comfortable with the cost of the loan?

•   Can you afford the performance percentage, even in a slow month?

•   Do you think the benefits you may get from the loan will outweigh the increased cost of these funds?

Recommended: Most Profitable Businesses to Start

6 Steps to Finding and Applying for Revenue-Based Business Loans

Here are the steps that are typically involved in getting revenue-based financing.

1. Figure Out How Much You Want to Borrow

Before you start looking for a lender, you’ll want to take some time to determine how much you want to borrow and exactly how you will use the funds. As part of the application process, you’ll typically need to submit your desired loan amount, along with a plan for how the loan proceeds will be spent and how these investments will help your business.

2. Prepare the Necessary Documents

Applying for a revenue-based loan is similar to applying for any small business loan in that you’ll likely need to gather appropriate paperwork that proves you are who you say you are and that your reported revenue is accurate. You may need to provide:

•   Personal and business income tax returns

•   Balance sheet and income statement

•   Personal and business bank statements

•   A photo of your driver’s license

•   Business licenses and permits

•   Articles of incorporation

•   Details on any other loans (if applicable)

•   Documented plan to increase your existing business revenue

However, there are some types of “no-doc” business loans that don’t require much documentation. These lenders are willing to approve borrowers based on credit history and collateral, but are likely to charge higher interest.

3. Compare Lenders

Banks and other conventional lenders generally don’t offer revenue-based financing. However, you may be able to find this type of loan through investment companies, financing institutions, revenue-based financing firms, and venture capital firms. Loan brokers may also be able to point you toward lenders offering revenue-based loans.

If you end up with multiple options, it can be a good idea to compare not just costs but also any other benefits the financing company offers. Some revenue-based lenders will act as mentors to your business since they have a vested interest in seeing your company succeed, which could be a valuable add-on.

4. Apply

You can typically apply online and, once you submit your application, your chosen lender will review and verify your monthly and annual revenue statements as well as your other submitted documents.

5. Waiting Period

Once you submit your application for revenue-based funding, the response is typically fast. You may hear back within as little as 24 to 72 hours.

6. Review the Loan Agreement Before Signing

If you’re approved for the loan, a representative will reach out and likely present a mix of options with varied repayment terms. You’ll have a chance to go over each option and ask any questions you may have. Be sure you read through the loan agreement you arrive at and thoroughly understand it before you sign off.

Alternatives to Revenue-Based Business Loans

If you’ve been denied for more traditional loan products, but you’re on the fence about going with a revenue-based loan, you might want to consider the following alternatives.

Business Credit Card

If you don’t need that much additional capital, you could consider a business credit card. You might be able to find a business credit card that offers a 0.00% introductory annual percentage rate (APR), which could help you get through any cash flow issues you may be experiencing. The zero-interest intro APR period could last as long as 18 months, which could help you pay business expenses without racking up any interest.

Microloan

What are microloans? Also known as microcredit, this type of financing provides small amounts of funding to help start or grow a business. These loans commonly target specific groups, such as women, minorities, veterans, or others who may face barriers to accessing bank loans and other traditional means of funding.

Peer-to-Peer Loan

Peer-to-peer (P2P) lending is when a borrower receives funding directly from other individuals, cutting out the financial institution as the middleman. Borrowers and investors typically connect on P2P lending websites. Each site sets the rates and the terms and enables the transaction. This may be a viable option if you’ve been repeatedly denied capital using a more traditional route.

Crowdfunding

With business crowdfunding, your company collects small monetary contributions from a large group of people through an online platform. In some cases, you don’t have to pay the money back – instead, you just give each investor a “reward.” However, developing a successful crowdfunding campaign can take a lot of time and effort.

Angel Investor

If you’re willing to part with a small amount of equity, an angel investor may be able to help. Angel investors are usually high-net-worth individuals who are able to provide needed capital to startups and young businesses in exchange for an ownership stake in the company.

SBA Loans and Business Lines of Credit

The Small Business Administration (SBA) partners with private lenders to make a variety of loans at favorable rates available to small business owners who might otherwise have difficulty getting funding. The SBA guarantees a portion of these SBA loans to reduce risk for the lenders, who issue most of the loans. These loans can involve a lot of paperwork, but some of them are specifically meant to be accessible to startups. There are also SBA lines of credit, which allow access to a set maximum of funds that a business draws on when and if it needs it. These lines can be especially helpful in case of emergencies or unexpected costs.

Recommended: Guide to Business Financing

The Takeaway

Revenue-based business loans are a way to get capital by pledging a percentage of future ongoing revenues. Payments reflect whatever percentage you’ve agreed you can afford, but overall, costs may be higher than they would be for traditional business loans. However, other small business financing options may have more stringent financial requirements.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

Can you get a revenue-based loan with bad credit?

Yes. The main deciding factor is your business’s total sales. If you have strong sales, then you may be a good candidate for revenue-based loans.

How do revenue-based business loans even work?

Revenue loans are a form of financing that allows small businesses to get capital upfront and pay it back from future revenues. Payments are based on a weekly or monthly percentage of revenues and continue until the financing is repaid along with the fee. The total cost is usually around 1.1 to 2.5 times the amount borrowed.

Is revenue-based financing good?

Revenue-based financing can be a good option if you’ve been turned down for other types of business loans because of a lack of collateral or a low credit score.

Do you have to have revenue to get a business loan?

Not necessarily. While many business lenders require prospective borrowers to meet minimum revenue thresholds to qualify for a loan, some loans are designed for new businesses that don’t have any sales yet.

Is revenue-based financing a loan?

Yes, revenue-based financing is a type of loan, and it must be paid back through a percentage of your revenues.

Photo credit: iStock/Hispanolistic

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

SOSMB-Q126-048

When small businesses apply for loans, lenders typically use guidelines to determine which loans they will approve, including what amounts and rates they may offer. One of the factors lenders look at is debt-to-income ratio (DTI).

A debt-to-income ratio provides a snapshot of a business’s debt in relation to its income. Although each lender can have its own debt-to-income requirements, a lower percentage is generally considered more desirable than a higher one. Businesses with lower debt-to-income ratios may also get approved for better rates and terms.

Here’s more on how these financial metrics are calculated and what’s generally considered a healthy debt-to-income ratio.

Calculating Debt-to-Income Ratio

To calculate debt-to-income ratio, simply divide the sum of your business’s monthly debt payments by its monthly gross income. The resulting number is your debt-to-income ratio: To express it as a percentage, multiply by 100.

Put mathematically, the calculation for debt-to-income ratio is:

(Total monthly debt / Gross monthly income) X 100 = Debt-to-income ratio

Like any other ratio, this one is only as good as the quality of the data used in the calculation. If you’re calculating it to see whether it falls within a lender’s guidelines, it’s important to be clear about whether the lender wants this figure to include only business debts and income or business and personal debts/income, since that can make quite a difference in the number.

When you’re totaling up monthly debt payments for this ratio, you’ll typically include mortgages, vehicle loan payments, minimum amounts due on credit cards, installment loans, and so forth. This figure would generally not include things like utility bills.

For the monthly income figure, be sure to use gross income (before taxes and other deductions are taken out).

Debt-to-Income Ratio Calculation Examples

Here are a few sample calculations:

•   Borrower #1: With a monthly income of $7,000 and monthly debts of $1,500, its debt-to-income ratio would be 21.4% (that’s ($1,500 / $7,000) X 100). If a new loan payment added another $300 to the company’s monthly debt, then the ratio would become 25.7% (that’s ($1,800 / $7,000) X 100).

•   Borrower #2: With a monthly income of $5,000 and monthly debts of $1,500,its debt-to-income ratio would be 30%. If a new loan payment added another $300 to the monthly debt, then the ratio would become 36%.

•   Borrower #3: With a monthly income of $9,000 and monthly debts of $3,500, its debt-to-income ratio would be 38.9%. If a new loan payment added another $300 to the monthly debt, then the ratio would become 42.2%.

Common Mistakes When Calculating Debt-to-Income Ratio

Although the formula for calculating debt-to-income ratio is straightforward, figuring out what to include can be surprisingly tricky. Some mistakes it’s easy to make include:

•   Using the entire amount of a debt, rather than the monthly payment.

•   Entering net income, rather than gross income, in the equation

•   Not using an average over time if your business income is seasonal

•   Forgetting to update your DTI as you incur debt or your revenue increases

Why Debt-to-Income Ratio Matters to Lenders

As you may have inferred from the equation, your debt-to-income ratio sheds light on how much of your monthly income has to be dedicated toward paying off existing debt. This has implications for how much cash your business may still have available each month. And it also suggests how well your company is managing its funds. For potential lenders, this is valuable information when they are considering whether to offer you a small business loan, for example.

How Lenders Use Debt-to-Income Ratio in Loan Decisions

Your debt-to-income ratio can help lenders assess both how well your business may be able to afford new debt and how well it handles its current debts. Thus, your DTI can help a lender decide whether to offer you a loan, as well as what interest rate and terms it might specify if it does offer you funding.

Debt-to-Income Ratio vs. Other Financial Metrics

Potential lenders look at more than just your DTI. Typically, they will investigate other financial metrics, too, to assess your creditworthiness, and they’ll likely want to review your credit reports, credit scores, and financial statements, among other documents.

One of the most important metrics lenders rely on is your company’s debt service coverage ratio (DSCR). This ratio basically compares your cash flow to your debt obligations. It measures how easily you can pay your monthly debts from operating income, and it’s frequently used in tandem with your DTI to assess your creditworthiness. Typically, a lender will want to see a DSCR of at least 1.25, which means that your business is able to generate 25% more than it needs to pay its monthly debts.

What Is a Good Debt-to-Income Ratio for a Small Business?

Each lender can set its own debt-to-income ratio guidelines for lending so what a good debt-to-income ratio is can vary, but many like to see a ratio below 36%.

For a lender with this requirement, borrower #1 in the example above would comfortably fit within this lender’s debt-to-income ratio parameters. The business in the second example is right on the nose. But the third business’s ratio is higher than the guideline permits.

Some lenders have a higher debt-to-income ceiling. Additionally, although this may be a central metric for many of them, it wouldn’t typically be the only standard that a small business would need to meet to get loan approval.

The debt-to-income ratio is often thought of in connection with applying for a loan. But it can have an additional impact on small businesses, even if a company isn’t currently looking to borrow money.

1. Tighter Cash Flow

When its ratio is high, this suggests that it might be harder for the company to meet debt obligations. If, for example, customers owe this business money but aren’t paying on time, this in turn could make it difficult for the business to meet its obligations, including payroll and payroll taxes.

2. Prone to Late Fees

When cash is tight, late fees can be triggered, which only adds to the business’s cash flow problem. In contrast, companies with low debt-to-income ratios and good cash flow may be able to take advantage of early payment discounts and benefit from a lower cost of goods. Plus, when a company pays its vendors promptly, its relationship with these suppliers can be strengthened.

3. Stagnant Business Growth

When a company has higher amounts of debt, the interest portion of its monthly payments can make it challenging to pay down the balances. That can then lead to even larger amounts of interest owed, making it difficult to manage or expand the business.

Recommended: What Exactly Is a Small Business?

How a High Debt-to-Income Ratio Impacts Financing Options

Having a debt-to-income ratio that your potential lender considers high can have a serious impact on your business’s chance of getting the funding you want. Chances are, a high DTI will mean that you’ll have to pay more in interest and get a smaller loan than you would otherwise. It may even mean that you’re refused for a loan altogether.

Lowering Your Business’s Debt-to-Income Ratio

Plenty of benefits can result from a lower debt-to-income ratio. Even beyond helping to fix the three problems listed above, a lower ratio can simplify getting a loan if and when you need it. It can also help your business get better terms and interest rates.

To try to lower your ratio, first take a close look at your financial statements. Know how much your business is paying for rent, wages, raw materials, supplies, and more. Then consider the following:

•   In what areas could money be saved? Talk to vendors to brainstorm ideas.

•   Are there ways to buy in bulk to reduce costs?

•   How can your business tweak its purchasing so that extra inventory and supplies don’t sit on the shelves?

•   What are the interest rates on your business’s loans? Are they good rates?

•   If your business sells multiple products, which ones are selling the best?

•   Which ones have the best margins (make the most profit)?

•   What is the standard margin for your industry?

•   What combination of price raising and cost lowering can get your margin to the sweet spot? How does this position your business and its pricing against its competitors?

Increasing Revenue Strategically

Considering the questions above can help you determine how to increase your revenue. Depending on your answers, you may be able to reduce costs, but you should also be able to finetune your pricing strategy and pinpoint which products and/or services are most cost-effective to offer. Additionally, exploring new markets may also help you increase sales.

Paying Down or Refinancing Existing Debt

As you’ll remember from the DTI formula, reducing your debt can improve your ratio. Using the questions above to cut costs may free up cash you can use to pay off your debts more quickly. Additionally, it can sometimes make sense to get a debt consolidation loan. When debt is consolidated at a lower interest rate, cash flow may be easier to manage.

Recommended: How to Price a Business

Examples of Small Business Financing

If funding seems like something that might help your business, there are many options available. Here are a few to be aware of.

Term Loans and SBA Loans

Term loans are a common kind of small business funding. Typically offered by banks, credit unions, and online lenders, these provide successful applicants with an upfront lump sum that they pay back, with interest, over a predetermined term.

Loans partially guaranteed by the Small Business Administration (SBA) are known as SBA loans. They’re offered by approved lenders and typically come with competitive rates and longer loan terms than comparable products without the SBA guarantee.

For term loans and SBA loans, requirements will vary depending upon the loan program and lender. In general, though, lenders will examine factors such as how a business earns its income, how the company is owned, where it operates, what other loans have been made to the business, and the creditworthiness of the applicant.

Business Lines of Credit

Business lines of credit are another popular funding form for small businesses, and they’re available from traditional and online lenders and can be partly guaranteed by the SBA. With a line of credit, your business may be approved to withdraw funds, up to a set maximum, as you need them. You pay interest only on what you take out, and often, as you repay the funds, you replenish the amount of money you can draw on again. This form of funding can be useful if you want to have money available to cover seasonal lulls or handle emergencies or unexpected opportunities.

Recommended: Business Loan vs. Line of Credit

Revenue-Based Financing

With revenue-based financing, a financing company may offer a lump sum to a company with the understanding that it will be paid back through a certain percentage of the company’s revenues each month. This means that the actual amount of the payment can vary from month to month. To approve an application, a lender will usually want proof that the business’s monthly revenue meets its thresholds, and it’s important to realize that these loans are typically more expensive than many other forms of lending.

Recommended: Guide to Business Financing

The Takeaway

Taking control of your debt-to-income ratio can help your business and its chances of getting funding at good rates. A healthy debt-to-income ratio is generally no higher than 36% – and lower is better.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

What is considered a good debt-to-income ratio for a small business?

While lenders have different criteria for small business loans, typically, a debt-to-income ratio below 36% is considered good for a small business, though an ideal debt-to-income ratio may be even lower.

How do you calculate a debt-to-income ratio for a business?

The formula to calculate a business’s debt-to-income ratio is (Total monthly debt / Gross monthly income) X 100.

Can you get a small business loan with a high debt-to-income ratio?

Yes, though it may be challenging. Typically, DTI is not the only factor a lender will use in deciding whether to extend you a loan. But you’ll probably have to show financial strength and reliability in other ways – such as your credit score – and you may need to offer collateral.

How can a business improve its debt-to-income ratio?

To improve your business’s DTI, you can work on increasing the company’s income and/or paying off its debt – or consolidating it at a lower interest rate.

Does debt-to-income ratio affect SBA loan approval?

Having a good debt-to-income ratio can significantly affect your business’s chances to get approved for an SBA loan.

Photo credit: iStock/LumiNola

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SOSMB-Q126-046

Net operating working capital (NOWC) is one measurement of a company’s financial health. It looks at how efficiently a company is managing its current assets and liabilities.

Unlike plain net working capital, net operating working capital excludes cash and cash equivalents, since they’re not tied up in operations. This means that net operating working capital is more closely tied to current cash flows and can serve as a more accurate indicator of a company’s ability to sustain cash flow in the face of changes or obstacles.

Read on to learn how to calculate net operating working capital, why it’s important, and how it differs from other measures of working capital – and to see an example of a NOWC calculation.

How Lenders View Net Operating Working Capital

Net Operating Working Capital (NOWC) essentially measures the operational efficiency of a company. It reveals whether the business has the wherewithal readily available to meet its day-to-day operational expenses without taking on additional debts. For lenders, it can help show how well a company is converting its inventory and receivables into cash. A good NOWC suggests that the day-to=day operations of a company are working effectively.

What Is Net Operating Working Capital?

To understand what net operating working capital is, it’s helpful to know what working capital is.

Working capital is the money available to meet your current (short-term) obligations. It’s calculated by subtracting current liabilities from current assets, as listed on the company’s balance sheet. Current assets are those that can be converted into cash within one year; current liabilities are obligations expected to be paid within one year.

Net operating working capital measures the difference between a firm’s current assets, such as inventory and accounts receivable, and its current liabilities, such as accounts payable and accrued expenses. Unlike net working capital, however, it excludes cash and cash equivalents, such as bank deposits and short-term investments, since they are not tied up in operations and can be converted into cash if needed.

NOWC also excludes debt (such as different types of small business loans) and interest-bearing securities, since these items represent a method of raising the necessary capital to fund ongoing operations.

Key Components

The assets and liabilities that are tied to operations are the crucial components of NOWC.These include:

•   Operating Current Assets. These are assets such as inventory and accounts receivable, which are needed to generate the company’s core revenue

•   Operating Current Liabilities: These are short-term costs such as accounts payable and any accrued expenses.

Unlike NWC, NOWC does not include cash and cash equivalents, but focuses exclusively on operating assets and liabilities.

What Is Net Operating Working Capital Used For?

Calculating NOWC provides a measure of your company’s liquidity — or, in other words, its ability to meet its short-term financial obligations. Having a high NOWC, for example, means it’s likely easier to pay your bills as they come due. In contrast, having a low NOWC means you risk not having sufficient funds to pay off outstanding liabilities and may not be able to remain solvent.

Once you have calculated your business’s NOWC, you can use it to analyze your firm’s financial health and compare it to industry benchmarks or its historical performance.

And there are several more ways this information can be useful to you.

Supporting Business Growth

Knowing your business’s NOWC can give you a good sense of how well-positioned your business is to grow. Having a high NOWC allows you to invest in growth opportunities when they come up and increase profits. If, on the other hand, your business has too little NOWC, it will probably lack funds to invest in future growth.

Evaluating Operational Efficiency

Operational efficiency means how well your business manages its resources to arrive at desired outputs, like revenue. Since NOWC focuses on operations and compares your company’s relevant assets and costs, a high NOWC can suggest that your business is optimizing its resources.

Recommended: Business Loan Calculator

Net Operating Working Capital Formula

Here’s a look at the net operating working capital formula:

Net Operating Working Capital (NOWC) = Operating Current Assets – Operating Current Liabilities

Operating current assets can include:

•   Accounts receivable

•   Inventory

•   Prepaid expenses

Operating current liabilities can include:

•   Accounts payable

•   Accrued expenses

•   Deferred revenue

Calculating Net Operating Working Capital

To calculate net operating working capital, you need to:

1.    Determine your company’s current assets. These are assets that are expected to be converted into cash within one year. Examples include accounts receivable, inventory, and prepaid expenses. You can find your company’s current assets listed on its balance sheet.

2.    Determine your company’s current liabilities. These are debts that are expected to be paid within one year. Examples include accounts payable and accrued expenses. You can find a company’s current liabilities listed on its balance sheet.

3.    Exclude cash and cash equivalents. Cash and cash equivalents are excluded from the NOWC formula because they aren’t tied up in a company’s day-to-day operations. These include bank deposits and short-term investments.

4.    Calculate net operating working capital. Subtract your company’s current liabilities (excluding any short-term loans that have been used to finance current assets) from its current assets (excluding cash and cash equivalents).

Recommended: Change in Working Capital

Working Capital vs Net Operating Working Capital

Net operating working capital (NOWC) and net working capital (NWC) are both financial metrics that can be used to evaluate a company’s liquidity and overall financial health. NWC, however, includes all of a company’s current assets and liabilities, including cash and cash equivalents. It’s calculated by subtracting a company’s current liabilities from its current assets.

NOWC, on the other hand, is a narrower measure that excludes cash and cash equivalents from current assets, as well as short-term debt that has been used to finance current assets from current liabilities.

NOWC is calculated by subtracting a company’s current liabilities (excluding any short-term debt used to finance current assets) from its current assets (excluding cash and cash equivalents).

As a result, NOWC tends to be a more precise measure of a company’s ability to fund its day-to-day operations. It hones in on the capital a company has tied up in its day-to-day operations, which is more relevant for short-term financial management.

Recommended: What Is a Small Business?

Net Operating Working Capital Example

Here is an example of how to calculate net operating working capital for fictional company ABC.

ABC’s operating current assets are:

Accounts Receivable = $5 million

Inventory = $30 million

Prepaid Expenses = $4 million

Total operating current assets = $39 million

ABC’s operating current liabilities are:

Accounts payable = $10 million

Accrued expenses = $7 million

Deferred revenue = $3 million

Total operating current liabilities = $20 million

We then plug these numbers into the NOWC formula:

Net Operating Working Capital (NOWC) = Operating Current Assets – Operating Current Liabilities

NOWC = $39 million – $20 million

NOWC = $19 million

Based on the operating working capital formula, ABC has a positive NOWC, which means it is capable of paying off all of its current operating liabilities and having some assets left over. This indicates that things are probably going well — ABC could meet its obligations all at once if needed and still have funds left to cover its current operations.

Common Mistakes When Calculating NOWC

One mistake it can be easy to make when you’re figuring out your company’s NOWC is to include cash or cash equivalent assets and/or short-term debt. Since these don’t pertain to operations, they should not figure in a NOWC calculation.

If your business is subject to seasonal swings, you may also get a misleading NOWC result if you focus on a specific moment in time, rather than using a longer time range or average.

The Takeaway

Net operating working capital measures a company’s short-term liquidity, meaning its ability to meet short-term financial obligations. If a company has a positive NOWC, it’s able to cover all of its liabilities. If it doesn’t, some aspects of the business are likely not operating as well as they could.

Some ways to improve your company’s NOWC include optimizing inventory levels to improve efficiency and cash flow, improving collections from customers, negotiating better payment terms with your suppliers, and increasing operational efficiency.

You might also consider financing options, such as a working capital loan, which can provide short-term financing to cover operating expenses or factoring, where you sell accounts receivable to a third party for cash.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

How are operating capital and operating working capital different?

Operating capital and operating working capital are the same thing: capital required to fund a company’s day-to-day operations. They can cover operational expenses, including accounts payable and accrued expenses.

What does net operating working capital include?

To calculate net operating working capital (NOWC), you subtract operating current liabilities (such as accounts payable, accrued expenses, and deferred revenue) from operating current assets (such as accounts receivable, inventory, and prepaid expenses).

What is net operating working capital an indicator of?

Net operating working capital (NOWC) is an important indicator of a company’s short-term liquidity and its ability to meet day-to-day operational expenses. A positive NOWC indicates that a company has sufficient current assets to cover its short-term obligations, while a negative NOWC suggests potential liquidity issues.

How can a business improve its net operating working capital?

Possible ways to improve your business’s NOWC can include optimizing inventory levels, negotiating with your suppliers to get better rates, improving your collections from customers, and boosting the efficiency of your operations.

Is a higher net operating working capital always better?

While a high NOWC can be a good sign, in certain situations it may signal a problem. Your business might have a high NOWC because you have too much inventory that is not moving, for instance.

Photo credit: iStock/miodrag ignjatovic

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

SOSMB-Q126-043