How much of a loan can your business really afford? Learn more about how lenders will determine your loan amount so you can evaluate your loan options.
Your Financial Picture
To understand where your company is financially, looking solely at the income statement can be misleading. Reviewing the balance sheet, statement of cash flows and understanding a company’s on-going capital requirements is crucial, and depending on the nature of your business and how you do your financial analysis, can be surprisingly difficult to nail down.
A good first step, for both your business and a prospective lender, is to be sure you have all the necessary documentation to obtain a loan. If nothing else, keeping a current balance sheet, P&L, etc., will give you an idea of where you stand financially at any given moment. (If you bring your financials up to date with the help of a bookkeeping services company, you might even find to your surprise that you don't even need a loan.)
With accurate financials in hand, you can get a bit more granular in determining the size and nature of the loan you need. Do you need a line of credit? A short-term bridge loan? Do you need to buy equipment, or would leasing be a better option? Or could it be that all you really need is a good rate on a business credit card?
How Does a Lender Determine Your Loan Amount?
It's also important to understand that different financial institutions use different metrics. That can influence not only whether a given bank or lending institution will provide a loan, but also what size a prospective loan could be. And when it comes to loans, bigger isn't necessarily better for your business.
How to Gauge Those Gauges
A lot depends on what a particular institution uses for a measuring stick. Take, for example, EBITDA (i.e. "earnings before interest, taxes, depreciation and amortization"). Basically, EBITDA provides an indication of a company's profitability and operating performance before factoring in the cost of capital investments or the cost of capital itself.
In many cases, EBITDA can be a useful gauge. For instance, if you had a thriving dental practice and wanted to open a second location that doesn't require a huge capital investment, a bank could reasonably determine your terms by using a multiple of EBITDA.
But because EBITDA doesn't include depreciation, it wouldn't account for the ongoing needs of businesses that require a continuous stream of capital expenditures. The takeaway is that you need to be sure you use the right criteria for determining the terms of any business loan.
Really, it's no different from shopping for the right type of home mortgage. You need to weigh a number of factors, such as debt-to-income ratio. And just as not every home-mortgage provider is necessarily looking out for your best interests, not every lending institution will offer a loan package that's appropriate for your business.
When Getting a Loan, Don't Go It Alone
There are far more variables than we can list here. That's why it's important to seek financial insight from an informed, objective third party. You need an analysis that's based on models of your type of business — not someone else's.