Business lenders put a high value on analyzing a borrower’s cash flow. It’s seen as having significant predictive value in whether the borrower can pay back the loan since it will usually be the primary source of funds for repayment. The financials that a lender requires varies but they will typically look at one or more of the following: bank statements, tax filings, and internal financials (such as a Profit and Loss statement and a Balance Sheet).
A good place to begin is your EBITDA – earnings before interest, tax, deductions, and amortization. This value should match across your records; in other words, the earnings you report on last year’s business tax filings should be the same that you’ve arrived at in your internal financials. Often, lenders will have a form that you will sign in applying for a loan that allows the lender to verify your tax records with the IRS. This means they will ensure that whatever tax records you supply match precisely with the ones that you filed. Lenders have been doing this a long time- and they have processes in place to check for data consistency across a borrower’s file.
How Earnings Impacts Debt Service Coverage Ratio
Debt service coverage ratio (DSCR) measures the availability of a business’ cash flow to pay its debt obligations. The formula is:
Earnings Before Interest and Tax (EBIT) / Total Debt Service Payments
A DSCR of 1 means that a business earns just enough to cover its debt obligations. It means that Earnings and Debt obligation payments are exactly equal and would cancel each other out.
Put yourself in the position of a lender. How comfortable would you feel if you let someone borrow money and learned that they earn just barely enough to pay back the debt? You know that any change in the borrower’s circumstances could be enough to reduce his ability to afford the debt- a reduction in income, an unexpected expense, etc. He is right at the razor’s edge and there is little margin for error. For this reason, lenders – whether they be banks or alternative lenders – look for a DSCR comfortably above 1. It varies but you may see a requirement of 1.15 for lenders with looser criteria or 1.25 for a lender with tighter criteria.
For example, the Small Business Administration (SBA) loan program, states the following in “Credit Standards for SBA Lending” for loans over $350,000:
Debt service is defined as the future required principal and interest payments on all business debt inclusive of new SBA loan proceeds. Business applicant debt service coverage ratio (OCF/DS) must be equal to or greater than 1.15 on a historical or projected basis;
The lender will consider not just existing debt obligations but the total debt obligations including the new loan. In the case of a business loan, the lender may evaluate the DSCR of both the business and the owner. A sufficient DSCR, as determined by analyzing a business’ cash flow, gives a lender confidence that its loan will be repaid. This is why cash flow ranks so highly to lenders when they evaluate the loan application.
Improving your Cash Flow
Improving your cash flow processes leads to a better financial picture and it therefore improves your standing for getting a business loan. Roughly speaking, there are two main processes affecting cash flow- accounts payable and accounts receivable. This relates to money you owe other companies and money you are owed.
Prioritize Collections & Advance Payment
Business owners often begin with a trusting attitude when it comes to their customers paying them what they are owed. The tasks of running a business easily fill the day, and the time and willingness to collect overdue payments sometimes isn’t there, especially since it often entails uncomfortable conversations. However, it’s necessary for a small business owner to prioritize collection from customers who are late on payments.
One solution to delayed payment is to collect payment upfront. When you start, more lenient payment terms may be used to ensure an initial customer base. As you earn trust with your customers, it is acceptable to ensure smooth business operations by insisting on being paid ahead of service or product delivery. If you have an ongoing service, you can bill at the beginning of the month or week. If you have adequate security measures, you can also keep the customer’s credit card on file and, with the permission of the customer, charge it at regular intervals.
In some cases, it may be appropriate to charge for more than one pay period upfront. For example, if you sign up for a WordPress.com blogging account, they cite a cost per month, but they inform the customer they will be charged on that per month basis for 12 months, up front. This allows the business, WordPress in this case, to augment their cash flow position by receiving the payment in their bank account as early as possible.
In a way, receiving upfront customer payment is a bit like receiving a loan from the customer- a kind of financing that provides cash immediately and allows you to attend to your business expenses with those funds.
Negotiate Payment Terms with Vendors
Many vendors offer varying payment schedules but don’t publicize them. For example, they may claim Net 30 days is standard but after a discussion with your vendor contact, they are willing to move your account to Net 60 days. The delayed payment terms businesses offer each other is called trade credit. Chances are, your business may have simply scratched the surface on what’s possible as far as fully taking advantage of trade credit with your vendors.
By pushing payments out further and receiving revenue sooner, your business before and after is technically the same. Your product or service remains the same, your customer base stays constant and so do your stable of vendors. But you are a very different company from a financial point of view – and this is what lenders are evaluating.
Cash Flow and Borrowing
Optimizing your cash flow is a good thing to do, period. It also has the advantage of bettering your chance at receiving a loan, or increasing the size of the loan you qualify for. If you’re interested in better understanding your company’s cash flow (as well as improving it), there may be a Small Business Development Center (SBDC) near you. SBDC’s are a program of the SBA; they are hosted by colleges and state economic development agencies. They provide classes and guidance on an array of subjects affecting small business owners, including how to track your cash flow & tips for how to keep your cash flow healthy.
The more familiar you are with your cash flow, the better you can explain the cost and revenue dynamics to your lender. Given the importance of cash flow, the reality is that a well-liked business with a product in-demand that doesn’t have a tightly watched and controlled cash flow may not be eligible for a loan. Meanwhile, a smaller business that has efficient methods of collecting payments from customers and has secured extended payment terms from the businesses it buys from, may well be eligible for financing.
Famed business consultant and author Peter Drucker once said, “Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.” This saying applies to small business lending as well.