Getting a small business loan may seem like a daunting task, especially if you aren’t totally familiar with the requirements. Small business loans are measured by a variety of financial ratios (or metrics) and percentages (APR, TIP, APY, etc.) to assess risk, measure cost, and ultimately help the lender (and you) make a decision on whether a loan is a good idea.
In this post, we will discuss the most important metric for small business loans, explain why it’s so important, and give you a simple trick to get the best terms you can.
The Most Important Metric
There are several categories of metrics that lenders will calculate: liquidity, affordability, debt ratio, profitability and others. All are important when you present your business plan and financial documents to a lender, but not all lending metrics are created equal.
One metric, more than any others, stands out as the single most important on any small business loan — both for the lender and for you, the business owner: affordability, measured by either debt service coverage ratio (DSCR) or debt to revenue ratio (DTR).
Why Is Affordability So Important?
Put simply, affordability is what makes or breaks a business. More than any other metric, it determines whether your business can support the loan. An unaffordable loan is still unaffordable, even if (or more often because!) the loan amount is nice and high or the APR is nice and low. If you saddle your business with debt you can’t afford to service, you’re headed for trouble.
Too many borrowers zero in on the APR or total interest paid on a loan while ignoring affordability. We’re all about low APRs here at Able. APR is a very useful tool for comparing the cost of a loan to other loans (as well as the ROI of the project). But it’s just a comparative/informative metric to help you see the true interest cost of a loan compared to other options. It’s not the end-all/be-all of a loan.
What Drives Affordability?
This is where a lot of borrowers get confused. Doesn’t APR affect affordability? Well… not really. Unless the APR is very high (30%+), APR has only a small effect on the affordability of a loan in absolute terms. Instead, affordability is driven almost entirely by (1) loan size and (2) loan term.
So if we were to pick a single metric that drives affordability, it would be term. Short-term loans are by their nature less affordable. For instance, the monthly payments on a 6-month loan will be almost 10 times higher than the monthly payments on a comparably sized 5-year loan.
What makes short-term loans and MCAs so problematic is not the APR per se (though some are so high that they affect affordability), but rather the term. A $500,000 loan isn’t very useful if you have to pay it back over 12 months.
Knowing all this, it’s fairly obvious to assume that if a bank or lender thinks that your affordability metric isn’t good enough, then you won’t be getting the loan.
Pro Tip: Game the System
If you’re like most borrowers, you want an affordable loan, but you also don’t want to pay too much in total interest.
The best way to to do this, in our opinion, is to find a long-term loan that is both affordable and has no prepayment penalties.
Because you want to plan for good times and bad times. If things go well, you can pay off your loan early, meaning you’ll pay less in overall interest. But if things go less well, you’ll be able to service the debt until cash flows improve.
Bonus Tip: Refinance Short-Term Debt
What else can you do to improve affordability? Well, affordability is a function of net income compared to debt service (DSCR), and net income is a function of revenue and costs. So you can obviously trim costs, but that’s often messy (especially for your employees…). Or you can pull in more revenue (simple as that…!).
But one often overlooked method to reduce costs without affecting your business or operations is refinancing short-term debt. You’ll pay more in interest in most cases, but your monthly cash flows will improve dramatically. Specifically, your net operating income will increase by the difference between the old monthly payment and the new monthly payment.
That will significantly juice your affordability (or just give you more cash to reinvest elsewhere in the business).
If you’re curious to see how much you can save, you can use our free calculator.