Debt to Income - One Way Business Bankers Evaluate Your Ability To Pay
By Dell Gines
During my time as a business banker I ran into numerous small business owners who were astounded when I told them they couldn’t receive a loan.
One of the most common responses was, “But I have all these assets for collateral!”
In banking, it is not enough to have collateral coverage. Banks work purely from the premise, “Am I going to get paid back on the loan”, which means that the business HAS to make enough money to cover its operational expenses AND be able to pay its monthly payment.
In this article, I will briefly explain how banks evaluate Debt to Income.
On a term loan, as mentioned above, banks want to see that a business has had, and with reasonable future expectations have, enough cash to pay back the principle and interest on a loan.
What this means is that during the normal process of business, bankers are going to look at whether or not historically there has been enough income to pay back all the cost of running the business, paying for the loan, and whether there was a sufficient cushion in case of emergencies.
They evaluate what is called a DEBT to INCOME ratio.
Let’s put debt to income ratio into a personal loan example. Say every month you brought in $1000 dollars worth on income from your job. Of that income, it cost you $500 dollars for all your monthly expenses which leaves you with $500 dollars left over.
You want to take out a loan, and the loan will be $250 dollars per month to pay back. In this example, you have $500 dollars of EXTRA money after your regular house cost, and you will be spending $250 per month more if you get the loan.
To calculate debt to income you simply divide the amount of money you had extra before the loan payment ($500) by the amount of the new loan payment you will have if you get it ($250). $500 divided by $250 equals 2 to 1 debt income ratio.
This means that you have TWO TIMES the income necessary to pay the debt. So if you lose $250 dollars in one month, you would still have enough left over to pay your loan payment.
Banks generally won’t lend to you if your debt to income ratio is 1.25 to 1 or less, so a 2 to 1 debt to income ratio in our example is good.
Here is the math:
Step 1 - $1000 per month income - $500 in expenses = $500 of left over income.
Step 2 - $500 of left over income divided by $250 in the new loan payment leaves you with a 2 to 1 debt to income ratio.
If we return to the business world with our debt to income measurement we perform a similar function with the difference being on how we calculate income.
As a banker, we calculate income by taking your NET INCOME from your tax return or financial statements and then add back TAXES and DEPRECIATION EXPENSE as a general rule.
So if you had a year end net income of $1000, and $500 in taxes, and $500 in depreciation, we would add them together to get $2000.
If your loan payment was going to be $1000 we would divide $2000 by $1000 and again get 2 to 1, a good debt to income ratio from a business banker’s perspective.
Bankers are risk adverse, they want to feel as comfortable as possible that if they give you a loan, they won’t have to collect on your collateral to pay it back.
This means that you have to maintain a positive debt to income ratio AT LEAST above 1.25 to 1.
Here are two key ways to improve your debt to income ratio are:
1. Reduce administrative and operations cost in your business. Remember anything that INCREASES your net profit, gives your more funds to pay back debt. By carefully controlling and reducing your operations and administrative cost, you increase the amount you have left over in net profit.
2. Seek a longer term loan. Remember, debt to income is calculated by income divided by loan payment. If you reduce the loan payment by making the terms longer, you increase your overall debt to income ratio.
Remember, to be bankable you have to be in the ranges that banks find tolerable when they evaluate whether your will be able to repay.
Maintain a good debt to income ratio and you are well on your way to getting the financing your business will need for growth.
Gines is the President and Founder of Centre for Economic Education and Development Inc (Ceed), based in Omaha, Nebraska. He is a banking and financial expert and has designed and taught numerous personal and business classes. He is a regular speaker on business at schools and conferences.
He blogs at Urbanceed
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