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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.
Key Points
• Calculating a business’s debt-to-income ratio involves dividing total monthly debt payments by gross monthly income, then multiplying by 100 to express the result as a percentage.
• Lenders generally prefer debt-to-income ratios below 36%, since lower percentages indicate stronger financial health and better capacity to manage existing and new debt obligations.
• Lenders use debt-to-income ratios to assess whether businesses can afford additional debt and how effectively current debts are being managed.
• Businesses with less-than-ideal debt-to-income ratios typically face higher interest rates, reduced loan amounts, or outright loan rejections when seeking financing from potential lenders.
• Improving debt-to-income ratios usually requires increasing company income, paying down existing debt, and/or consolidating multiple debts at lower interest rates to reduce monthly payment obligations.
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
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