Entrepreneurs often face a dilemma when deciding how much to borrow for their businesses. If they borrow too little, they may not have enough cash to meet their needs. But if they go into excess debt, they may not be able to meet their payment obligations INCOME RATIO.
Is there a way to calculate the ideal level of debt for your business?
Fortunately, there is. The debt-to-income ratio can help determine your debt limit.
What is the debt-to-income ratio?
Your debt-to-income ratio indicates the proportion of your monthly income that goes to pay off your debt. It can be calculated as a percentage.
The procedure to calculate this relationship involves knowing:
- Your total monthly debt payment obligation.
- Your gross monthly income.
Some lenders verify an applicant’s debt-to-income ratio before approving a loan.
Lenders view a low ratio favorably. Knowing your debt-to-income ratio tells lenders if you are in a position to repay the loan.
However, a high debt-to-income ratio sends the opposite message: a lender may not approve your loan.
How to calculate the debt-to-income ratio
This is the formula for calculating the debt-to-income ratio:
Debt to Income Ratio = Total Monthly Debt Payments ➗ Total Gross Monthly Income
Let’s understand how the debt-to-income ratio is calculated with the help of an example. If you multiply the result by 100, you will have the percentage of the ratio.
Camila, who runs a small restaurant, has borrowed money from an online lender to pay for new kitchen equipment. You can calculate your debt to income using the following information about your business:
Camila’s total monthly debt payments: $ 2,000
Gross Monthly Restaurant Income: $ 6,000
Debt-to-income ratio = ($ 2,000 ➗ $ 6,000) ✖️ 100 = 33%
This calculation tells Camila that one-third of her monthly income will be used to pay off her debts.
What is a good debt-to-income ratio?
As a general rule, a lower ratio is considered better.
A ratio of, say 10%, would indicate that only one-tenth of the available funds are being used for debt repayment.
However, if the ratio were higher, say 60%, it could be a sign of over-indebtedness. If 60% of a company’s gross income were used to pay off debts, it would leave very little money for other expenses.
A ratio that is equal to or less than 36% is considered acceptable. A low ratio indicates that you can borrow more. However, if the ratio is high, you should focus on ways to reduce it instead of getting more debt.
Here is a table that illustrates how lenders would interpret your ratio:
Debt-to-income ratio: percentages
10% – A comfortable relationship. You shouldn’t have a problem getting a loan as long as you meet the other requirements of the lender.
20% – This is also a good ratio. It should be easy to get more money for your business.
36% – You are at your limit. If you need more funds, you will need to convince the lender that you will be able to pay.
40% – It can be difficult to get a positive response to your loan application. But don’t give up. You may be able to find a lender who is willing to approve you for a loan.
50% or more – You probably shouldn’t borrow more. Instead, you should focus on improving your debt-to-income ratio.
How to fix a bad debt-to-income ratio
What if you have a bad debt-to-income ratio and your business needs funds?
How will you raise the money you need?
There are several ways that you can overcome this problem.
1. Lower the cost of your loan
In an earlier section of this article, the method for calculating the debt-to-income ratio was explained. Let’s go back to the formula:
Debt to Income Ratio = Total Monthly Debt Payments ➗ Total Gross Monthly Income
If you analyze the formula, you will notice that a higher amount of “Total Monthly Debt Payments” will result in a higher ratio. But by reducing your existing loan costs, you can reduce the amount you pay for loan payments each month.
How can you reduce your borrowing costs?
One way to do this is to use a business loan as a debt consolidation loan. This involves paying off your existing high-cost debt with a new loan. Remember that this method only works if the debt consolidation loan has a lower interest rate than your current loan.
At Camino Financial we offer small business loans with rates ranging from 12% to 24.75%. If you are currently paying a higher rate, you might consider getting a loan from us. This could help you reduce your debt and increase your earnings.
2. Invest in assets that bring you a good return
Business owners can be overly optimistic when calculating the profitability of new investments. They make the mistake of overestimating the revenue they will generate and underestimating the costs.
If you fall into this trap, you will get a lower return on investment (ROI) than you expected. The earnings may not be enough to pay off the loan you have taken out.
What should you do if you find yourself in this situation?
Take a careful review of the income your assets generate and the profits you make from them. If an asset is used suboptimal or is dormant, it may be best to sell it and prepay one of your loans.
3. Increase your sales
Take another look at the debt-to-income formula. The denominator in the formula is your gross monthly income. If you can increase this amount, your debt-to-income ratio will decrease.
This example illustrates how this happens:
Scenario 1
Total monthly debt payments: $ 2000
Total gross monthly income: $ 10,000
Debt-to-income ratio: 20%
Scenario 2
Total monthly debt payments: $ 2,000
Total gross monthly income: $ 12,000
Debt-to-income ratio: 16.7%
As you can see, an increase in increase in monthly gross income has resulted in a decrease in the debt-to-income ratio.
Focus on marketing your product or service. A push in this direction could lead to more sales and control your ratio.
Increasing your business income will also provide you with more cash flow. This will help improve your bank balance and strengthen your financial position.
4. Improve your credit score
Many lenders link the interest rate they charge to your credit score. A higher score will give you a lower interest rate.
If your score is bad, you should work to increase it. There are several ways to improve your credit score.
