When small businesses apply for loans, lenders typically have guidelines to determine which loans to approve, including amounts and rates. One of the factors lenders look at is your debt-to-income ratio (DTI).
A debt-to-income ratio provides a snapshot of a business’s debt in relation to its income. Although each lender can have its own debt-to-income requirements, a lower percentage is generally considered more desirable than a higher one. Businesses with lower debt-to-income ratios may get approvals at better rates and terms.
Here’s more on how debt-to-income ratios are calculated and what’s considered a good ratio.
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Calculating Debt-to-Income Ratio
To calculate debt-to-income ratio, simply divide the sum of your business’s monthly debt payments by its monthly gross income. The resulting percentage is the debt-to-income ratio. To express it as a percentage, multiply by 100.
Put mathematically, the calculation for debt-to-income ratio is:
(Total monthly debt / Gross monthly income) X 100 = Debt-to-income ratio
Like any other ratio, this one is only as good as the quality of the data in the calculation. If you’re calculating it to see whether it falls within a lender’s guidelines, it’s important to be clear about whether the lender wants this figure to include only business debts and income or business and personal debts/income, since that can make quite a difference in the number.
When you’re totaling up monthly debt payments for this ratio, typically you’ll include mortgages, vehicle loan payments, minimum amounts due on credit cards, installment loans, and so forth. This figure would typically not include things like utility bills.
For the monthly income figure, be sure to use gross income (before taxes and other deductions are taken out).
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Debt-to-Income Ratio Calculation Examples
Here are a few sample calculations:
• Borrower #1: With a monthly income of $7,000 and monthly debts of $1,500, the debt-to-income ratio would be 21.4% (that’s ($1,500 / $7,000) X 100). If the new loan payment added another $300 to the company’s monthly debt, then the ratio would become 25.7% (that’s ($1,800 / $7,000) X 100).
• Borrower #2: With a monthly income of $5,000 and monthly debts of $1,500, the debt-to-income ratio would be 30%. If the new loan payment added another $300 to the monthly debt, then the ratio would become 36%.
• Borrower #3: With a monthly income of $9,000 and monthly debts of $3,500, the debt-to-income ratio would be 38.8%. If the new loan payment added another $300 to the monthly debt, then the ratio would become 42.2%.
Now that you know how to calculate your debt-to-income ratio, the next question is what do these debt-to-income ratios mean? And what’s a good debt-to-income ratio for a company?
What Is a Good Debt-to-Income Ratio for a Small Business?
Each lender can set its own debt-to-income ratio guidelines for lending, but many would like to see a ratio of 36% or lower.
For a lender having this requirement, borrower #1 in the example would comfortably fit within this lender’s debt-to-income ratio parameters. The business in the second example is right on the nose. But the third business’s ratio is higher than the guideline.
Some lenders have a higher debt-to-income ceiling. Although this may be a central metric for many of them, it wouldn’t typically be the only guideline that a small business would need to meet to get loan approval.
The debt-to-income ratio is often thought of in connection with applying for a loan. But it has additional impact on small businesses, even if a company isn’t currently looking to borrow money.
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1. Tighter Cash Flow
When the ratio is high, this suggests that it might be harder for the company to meet debt obligations. If, for example, customers owe this business money but aren’t paying on time, this in turn could make it difficult for the business to meet its obligations, including payroll and payroll taxes.
2. Prone to Late Fees
When cash is tight, late fees can be triggered, which only adds to the business’s cash flow problem. In contrast, companies with low debt-to-income ratios and good cash flow may be taking advantage of early payment discounts and benefiting from a lower cost of goods. Plus, when a company pays its vendors promptly, this can strengthen its relationship with these suppliers.
3. Stagnant Business Growth
When a company has higher amounts of debt, the interest portion of its monthly payments can make it challenging to pay down the balances. That can then lead to even larger amounts of interest owed, making it difficult to manage or expand the business.
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Lowering Your Business’s Debt-to-Income Ratio
Plenty of benefits can come from a lower debt-to-income ratio. Even beyond helping to fix the three problems listed above, a lower ratio can simplify getting a loan if and when you need it. It can also help your business get better terms and interest rates.
To try to lower your ratio, first take a close look at your financial reports. Know how much your business is paying for rent, wages, raw materials, supplies, and more. Then consider the following:
• In what areas could money be saved? Talk to vendors to brainstorm ideas.
• Are there ways to buy in bulk to reduce costs?
• How can your business tweak its purchasing so that extra inventory and supplies don’t sit on the shelves?
• What are the interest rates on your business’s loans? Are they good rates?
• If your business sells multiple products, which ones are selling the best?
• Which ones have the best margins (make the most profit)?
• What is the standard margin for the industry?
• What combination of price raising and cost lowering can get your margin to the sweet spot? How does this position your business and its pricing against its competitors?
The goal behind contemplating these questions is to free up more cash, which can in turn be used to pay down debt and lower the debt-to-income ratio. Besides finding ways to reduce expenses, increase revenue, and negotiate with vendors, it sometimes makes sense to get a debt consolidation loan. When debt is consolidated at a lower interest rate, cash flow may be easier to manage.
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Examplesles of Small Business Financing
If funding seems like something that might help your business, there are many options available. Here are a few to consider.
SBA loans. SBA loans are guaranteed by the Small Business Administration (SBA). They’re offered by approved lenders and typically come with competitive rates and longer loan terms. Small business loan requirements will vary depending upon the loan program and lender. In general, though, lenders will examine how a business earns its income, how the company is owned, where it operates, what other loans have been made to the business, and the creditworthiness of the applicant.
Inventory financing. With inventory financing loans, your business gets a loan to purchase inventory. For the lender, the inventory you’re purchasing with the loan serves as collateral. Typically, the amount of financing is calculated on a percentage of the inventory’s value.
Other types of small business loans include term loans, business lines of credit, equipment financing, merchant cash advances, microloans, commercial real estate loans, and more.
The Takeaway
Taking control of your debt-to-income ratio can help your business and its chances of getting funding at good rates. Ideally, you should aim to have a debt-to-income ratio no higher than 36%.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
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