When bankers consider making a loan to your business, they want to be assured the loan will be repaid on time. The type of debt that’s already on your books will be a factor in that decision.
Let’s take a look at the different types of debt, both business and personal, and see how they can affect an application for a business loan.
Types of Business Debt
Businesses have 2 types of debt: secured and unsecured
Loans that are backed by specific collateral are considered secured. If the borrower defaults, the lender has the right to repossess and sell the underlying assets and apply the sale proceeds to the loan balance. If a deficit remains, the lender could pursue collection actions against any guarantors.
For example, a loan to purchase a utility truck would have payments spread over several years and would be paid out of the company’s cash flow. The truck would be the security for the loan.
Another example is a loan used to buy a new computer system to manage accounts receivable and inventory. This would also be a term loan with payments coming out of the company’s cash flow.
Debt Service Coverage Ratio
One metric that banks look at is the business’s debt service coverage ratio. This metric is calculated by dividing the company’s free cash flow by its annual debt payments of principal and interest.
It measures a company’s ability to pay all of its debt obligations out of its operating income. Most lenders like to see a debt service coverage ratio of at least 3.1. This means that the company has $3 in income for each $1 in debt payments, including principal and interest.
The objective of maintaining a 3.1 ratio is to provide a margin of safety in the event of a decline in operating income or worsening economic conditions. Suppose a company’s income drops to the point where it has $2 in income for each $1 in debt payments; it would still be able to meet its debt payments without going into default and have funds left over to pay expenses.
If you’re applying to your bank for another term loan to finance the purchase of more equipment, the bank is going to recalculate a revised debt coverage ratio with the additional loan payments. If that ratio falls below 3.1, the bank will be leery about granting you more term loans that increase debt payments to an uncomfortable level in relation to the company’s cash flow.
One type of secured revolving debt are loans to finance inventory and outstanding receivables. A lender makes advances of a certain percentage against the value of the inventory and receivables. The underlying assets serve as collateral for the revolving line of credit, which is repaid out of the conversion of assets from inventory to receivables to cash.
Once these assets, inventory and receivables are pledged as collateral for revolving debt, they cannot be used to secure another loan.
If you’re in need of more short-term financing for working capital and your inventory and receivables are already pledged, you’ll have to take a different approach, perhaps considering unsecured loans.
For unsecured loans, banks require a healthy balance sheet in addition to a comfortable debt service coverage ratio. The strength of a balance sheet is measured by the company’s debt-to-equity ratio. It is found by dividing a company’s total debt by its shareholders’ equity. For small businesses, a good ratio is a minimum of $1 in debt for $1 in equity.
Banks look for this debt/equity ratio to provide a margin of security in the case of loan defaults. This ratio becomes especially important when a large portion of a company’s assets are already pledged as collateral for secured loans.
An owner’s guarantee is helpful to receive unsecured loans from lenders because, in the case of default, the lenders do not have any specific assets to attach and must rely on any proceeds being left from a total liquidation of the business for repayment of their loans.
Types of Personal Debt
When you’re a small business owner, it’s highly likely a lender is going to ask for your personal guarantee because, in reality, you and the business are the same entity. This means that the lender is going to pull up your personal credit history and check your FICO score.
A high score will boost your chances of getting a business loan while a low score will increase lenders’ concerns. Therefore, it makes sense to work on your own credit status to strengthen your guarantee for business loans.
So, how do the different types of debt affect your credit score?
As with business ratios, lenders will look at your personal debt service coverage ratio. This is the ratio of your current fixed debt payments to your income.
Like most homeowners, your mortgage is your biggest monthly payment. If it’s high in relation to your income, lenders could feel you’re not in a position to take on additional payments if you personally had to assume your business’s loan payments.
A lender could also be looking at the equity in your home as additional collateral. A large mortgage with little equity would not add as much as a second mortgage would for the security of a business loan.
Lenders are interested in how you’re managing your credit cards. Are they maxed out, or is the utilization portion at a more manageable level, such as 30%?
High credit card payments, even at minimum amounts, can lead to a high debt-to-income ratio. If lenders see that you have a lot of credit card debt with high payments, they will have more concerns about how you will handle your company’s debt obligations.
On the other hand, low credit card debt is more reassuring to lenders. In the worst case, you could use credit cards to make payments if the business was not generating enough cash flow on its own operations.
Student loans can be a good source to strengthen your credit history if you’re making payments on time.
Making on-time payments on any type of debt will improve your credit score and strengthen your guarantee in the eyes of the lender. In addition, lenders would look favorably on someone who used these loans to pay for a better education.
How Types of Debt Affect Credit Scores
The types of debt you have send a message about how you use your money.
As a rule, if you borrow money to buy something that increases your net worth or will have future value, that’s good debt. A mortgage on a home is an example of a good debt.
Over the long haul, a house is going to increase in value. At the same time, you’re paying down the mortgage and increasing the equity in your home and increasing your net worth.
If you have received a mortgage, that means a lender found that your debt-to-income percentage was reasonable, probably 43% or less. A lender contemplating making a loan to your business will look favorably at your mortgage and payment history.
Borrowing money to buy something that starts losing value the minute you buy it is an example of bad debt. Unfortunately, that includes many staples of modern life, such as cars, clothes and flat-screen TVs.
Having a few credit cards is both good news and bad news. When managed properly, they can be a good sign to lenders that you know how to responsibly manage your finances. That’s a plus when you’re asked to guarantee a business loan. But, it’s a negative if you’re overextended.
This is another type of loan with mixed messages. A car’s value starts to depreciate the day it leaves the dealer’s lot; it’s fairly quick for an auto loan to go underwater.
Of course, most people need a car to get to work and don’t have $20,000 to $30,000 to pay in cash. The point is to use common sense when taking out a car loan.
Don’t take out a loan to buy an expensive car with $700 to $800 monthly payments; it might put your debt-to-income ratio over the limit. On the positive side, a car loan with reasonable payments made on time will improve your credit score and strengthen your guarantee for business loans.
The different types of debt, both business and personal, represent opportunities to improve a company’s credit standing in the eyes of potential lenders. It’s important to understand how these types of debt affect applications for business loans. Once you understand the influence of different debts, you can address them and improve them to your advantage.