3 Steps to Calculate if Credit is PROFITABLE for the Business
Obviously receiving extra capital always sounds tempting. But remember why you took out credit in the first place: to grow your business. Always ask yourself, if the business loan you’re considering is profitable for your business.
That’s what the objective of this article – to help you make the right decision.
Here are the 3 steps to follow in order to calculate if credit is profitable for the business:
- Calculate DSCR
- Calculate Loan Profitability
- Calculate Alternate Factors
It means Debt Service Coverage Ratio. This is used by the lenders to determine your ability to pay back your credit with the free monthly cash flow you have.
The formula for calculating your DSCR is quite simple:
Monthly Earnings (After Expenses) ÷ Monthly Debt Payment = DSCR
Example: If you have a loan with monthly payments of $3,000 and your monthly earnings (after expenses) are $6,000 then:
DSCR = $6,000/$3,000 = 2
DSCR>=2: Your DSCR is 2, as you have twice as much free cash as the cost of your credit. This means that, you can afford the loan comfortably.
DSCR<=1: You shouldn’t take out a loan, if the monthly costs make your DSCR less than 1. Because it means it would be impossible to repay. The healthiest thing is to take out loans with an DSCR of at least 1.5 or more.
2. Calculate Loan Profitability
Not all types of equity are right for your business. Always calculate the following factors to find out, if that source of capital is profitable for your business:
a) Calculate Total Cost:
Calculate the total cost of financing and understand if the terms really suit you.
Be sure to include all costs, such as:
- Origination fee
- Annual interest
- Loan term
- Total loan amount
- Whether the loan also requires collateral
b) Cost of borrowing vs. return on investment:
If the cost of your loan is 25% annual interest and your margins are 75%, then it’s worth taking a finance. Because you would earn more than it would cost to finance that return. But if your interest is 24% and your margins are 20% then you will be losing money.
3. Calculate Alternate Factors
Remember not to just focus on monetary factors like interest. But also consider the following alternate factors:
Calculate Processing Time: Business loans can take 90 days or more just to be processed, depending on the financial institution you have applied with. Remember to consider how long the credit process would take and whether your business has the luxury of waiting that long to save a little more interest.
Potential Losses: If you don’t take funding or if the process takes too long, what would happen? If by not having funds, you would lose your most important client or part of your staff, then these are other critical points to consider.