Are you looking into outside financing to grow your business? If so, there are several financial ratios used by banks to assess the health of your business. Read on to learn more about Business Debt Coverage.
What is Business Debt Coverage?
Business Debt Coverage is a ratio that measures your company’s ability to repay business debt, providing a snapshot of the overall financial health of your business. The ratio compares your company’s cash flow to its total annual business debt payments. To calculate, divide your annual business cash flow by the annual business loan payments, including the anticipated payments you would make on the loan you’ve applied for.
Note that banks can use slightly different approaches when calculating Business Debt Coverage in terms of what expenses they include and how they define cash flow or debt.
Why is Business Debt Coverage important?
Business Debt Coverage is important to SBA banks because it helps to assess if there is enough business cash flow to cover the payments for all business debts. In other words, do you have funds each month to pay back a loan? A high ratio indicates you’re better able to pay back debt and can take on more debt if necessary.
What Should Your Goal Be?
Once you’ve used the calculation above, you’ll determine the Business Debt Coverage ratio.
- A ratio greater than 1 means your business has enough income to pay off its debts.
- A ratio less than 1 indicates your business does not have enough funds to pay back a loan.
For example, a Business Debt Coverage of .95 means that there is only enough income to cover 95% of annual business debt payments.
Factors to Improve Your Score
The good news is that businesses can improve their Business Debt Coverage ratio in two ways:
1) Increasing cash flow
2) Decreasing debt
Increasing Cash Flow
Cash flow problems can sink a business that might otherwise survive. According to a U.S. Bank study, 82 percent of business failures are due to poor cash management. Below are a few strategies you can use to increase your cash flow.
- Speed Up Cash Receipts
Billing can be a challenge for small business owners. Shortening your receivables, from 60 – 30 days for example, can boost cash flow. Encourage on-time payments by offering a small discount or instigating a penalty for late payers. Monitor receivables weekly or bi-weekly and follow-up on late receipts.
- Beef Up Marketing Efforts
Are you staying in touch with your current customers and reaching out to potential customers? One easy way is to send an e-mail blast reminding customers about your products or services. For additional ways to increase marketing, visit the SmartBiz Small Business Blog and review these two posts:
- Reduce Fixed Costs
Fixed assets with monthly payments can cause negative cash flow. Vehicles, equipment and other necessary expenses fall into this category. Consider leasing to avoid depreciating assets. Do an overall cost analysis to determine if you’re getting the best deal possible for insurance, tech services, phone and other reoccurring expenses.
For an in-depth look at these strategies, check out this article on the SmartBiz Small Business Blog: Small Business Cash Flow Fixes
Another way to sink a business? Accumulate expensive or unnecessary debt. Here are several ways to reduce debt to improve your cash flow.
- Keep Moving Forward We’ve talked to many small business owners who are buried under high cost debt. The related stress level can cause you to slow down sales, marketing and overall growth strategies. Keep your foot on the gas while you’re handling debt.
- Negotiate Are customers not paying on time? Negotiate payments so that some cash flow is coming in. Reach out to your vendors to determine if you can reduce monthly payments or renegotiate payment structure.
- Prioritize Debt Payments Pay down your most expensive debt first. That probably means tackling high-interest credit cards. Learn more about this method: How to Pay Off Business Debt with the Stack Method
- Seek Professional Advice Do you work with an accountant or another financial professional? They can offer suggestions to get a handle on it all. If you don’t have someone on board, look for free resources and guidance through your local Small Business Development Center.
Not sure if you qualify for an SBA loan? Try the new SmartBiz Advisor™ online, educational tool to learn about how you can get your business SBA or bank loan ready before you apply – no cost involved. You can assess key criteria banks consider and where your business stands on each. Learn more about SmartBiz Advisor here.
*What you need to know: The information provided through SmartBiz Advisor, including the Loan Ready Score, is for educational purposes only. SmartBiz Advisor is not a financial or legal advisor as defined under federal or state law. Use of this information is not a replacement for personal, professional advice or assistance regarding your finances or credit history.