Here's a common scenario among small business owners nationwide: their companies experience strong sales revenues and profits during a given quarter. However, when they apply for additional growth capital, they are approved with unfavorable rates and terms, or in some cases, their loan or financing applications are rejected. The reason for this is often excess business debt.
If you run a small business, it is important to understand its debt-to-income ratio (DTI). This financial metric compares a business's monthly debt payments to its gross monthly income. In short, it provides a clear picture of how much of your company's income is going toward paying off debts. Read this Huddle Business Capital blog article to learn about the debt-to-income ratio, including how to calculate it.
What is the debt-to-income ratio?
As mentioned earlier in this Huddle Business Capital blog article, the debt-to-income ratio is a financial metric that provides a bird's-eye view of a company's debt in relation to its income. A low debt-to-income ratio indicates a business has enough income to cover its debts. This shows strong financial health and can help business owners secure business loans, equipment financing, and other types of funding with favorable rates and terms.
Conversely, a high debt-to-income ratio makes it challenging for businesses to meet regular obligations such as employee payroll, operational expenses, and vendor payments. Moreover, businesses that carry more debt than can be managed can hinder their ability to secure funding.
How to calculate debt-to-income ratio.
You will be glad to know that calculating your business's debt-to-income ratio is simple and straightforward. The first step is to review your company's financial documents for a given time period and ensure that debt, income, and all other numbers are accurate. Next, divide your company's total monthly debt payments by its gross monthly income and multiply the result by 100 to get the percentage.
To illustrate this, we will use a local bakery as an example. The bakery has a monthly income of $15,000 and a monthly debt of $5,000. To calculate the bakery's debt-to-income ratio, divide $5,000 (total monthly debt) by $15,000 (total monthly income) and multiply the result by 100.
Here is the result:
$5,000/$15,000 = .333 x 100 = 33.3% debt-to-income ratio
Keep in mind that your business's debt-to-income ratio will only be accurate if you maintain up-to-date accounting records. Any inaccuracies or missing numbers will result in an incorrect ratio.
What is a good debt-to-income ratio?
A good business debt-to-income ratio varies by industry and the company's unique financial situation. That said, a 35% or lower debt-to-income ratio is considered healthy. Lenders are more likely to extend funding to businesses that have low debt-to-income ratios because they are seen as less risky. Debt-to-income ratios of 36% to 50% indicate adequate debt management but can impact borrowing ability.
Ratios exceeding 50% mean that more than half of a business's income is used to pay its monthly debt. This financial strain makes less money available to cover unexpected expenses or invest in new initiatives. Plus, lenders often view higher debt as a sign of risk and may be hesitant to provide capital or may do so at higher interest rates.
How to lower your company's debt-to-income ratio.
A low debt-to-income ratio offers several benefits to your business. It helps optimize your company's cash flow, ensuring you have enough cash to pay your bills, manage debts, and pursue growth opportunities. In addition, a low debt-to-income ratio can improve your chances of securing business funding with competitive rates.
If you determine that your company's debt-to-income ratio needs improvement, there are strategies to consider. These include paying off high-interest debts, negotiating better terms with creditors, consolidating debt, and reducing the usage of business credit cards and lines of credit. Doing so can lower your company's debt-to-income ratio, improve cash flow, and reduce financial stress.
Debt-to-income ratio and borrowing.
The debt-to-income ratio is one of several factors that lenders consider when reviewing a business's loan or financing application. Other factors include credit scores, time in business, and annual revenue. Still, a business with a lower ratio is more likely to meet its financial obligations in a timely manner, which gives it a significant advantage when applying for funding. Lenders prefer to see low debt-to-income ratios before approving loans and financing to applicants.
If your company's ratio exceeds 35%, you can still qualify for funding, provided you meet the other lender criteria. Before submitting your application, please discuss this with your lender so you are fully aware of their borrowing requirements.
Disclaimer.
This Huddle Business Capital blog article is purely educational and contains general information and opinions; it is not intended to provide advice or recommendations of any kind.
