What to Consider Before Refinancing Small Business Debt

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Eventually, there comes a time when small business owners set their sights on growth and expansion. Doing so often requires more capital, and many small business owners consider replacing their existing business debt with a new, more affordable loan. This process is called refinancing and can be a critical step to grow your business.

When done correctly, refinancing your business debt can lower your monthly payments, APR, and interest payments, improve your overall credit score, and most importantly, free up cash flow to invest back into the business.

Once you’ve made the decision to refinance your business debt, consider the following questions before you reach out to a lender and start the application process:

1. What are lenders looking for when analyzing your business’s financial performance?

Lenders will request your tax returns and your interim financials when considering your business for refinancing.  Before applying, make sure you have all of your business financials prepared so that lenders can analyze the financial position of your business and get a full understanding of its  historical performance. Lenders will request the following:

  • Corporate tax returns (3 years)
  • Personal tax returns (3 years)
  • The interim profit and loss statement
  • The interim balance sheet statement

Once the financials are submitted, the lender will be able to analyze the business’s EBIDA, or earnings (net income or loss) before interest, depreciation and amortization.  EBIDA is calculated with the following formula: net profit + interest + depreciation + amortization. This metric helps lenders gauge if your business has the capacity to payback monthly payments. Let’s look at an example of how EBIDA is calculated:

Gross Revenue/sales $50,000
less: COGS $2,000
Gross Profit $48,000
   
Operating Expenses  
Salaries $28,000
Rent $12,000
Marketing $2,000
Depreciation $2,000
Interest $500
Total Expenses $44,500
   
Net Income/Loss $3,500

EBIDA = $3,500 + 500 + 2,000 = $6,000. $6,000 is the cash available to pay back your debt

2. What is your business’s current level of debt since the original loan was made?

Lenders want to know what the debt service coverage ratio (DSCR) is for your company, or the ratio of cash your business needs to make the yearly payments to interest and principal on the debt acquired for a particular period.This ratio is used to determine the business’s solvency or the ability to pay off debt. DSCR is calculated by: net operating income / annual debt obligation. Follow the example below to find these figures:

  1. Review all your existing business debt and its terms. Before reaching out to a lender, consider creating a chart, like the one shown below, that clearly details all the information required to find the monthly and yearly payments on your debt.
Creditor Original Amount Original Date Present Balance Rate of Interest Maturity Date Monthly Payment Original Purpose
ABC $10,000 10/1/2017 $7,300 20 10/1/2020 $373 Inventory
XYZ $5,000 10/1/2017 $3,650 20 10/1/2020 $186 Inventory
Total Monthly DS $559
Total Annual DS $6,708

In the example above, the annual debt service is $6,708. Annual debt service is calculated  by adding together the monthly principal and interest payments and multiplying the sum by 12. Once you have your total annual payments or debt service, compare this number to your business’s EBIDA. Using the example above, the EBIDA is $6,000.With these two figures, you’ll be able to calculate your DSCR. The formula for DSCR is:

DSCR = EBIDA/DS

Let’s use our example to determine the DSCR:

DSCR = 6,000/6,708

DSCR = .89

Your DSCR needs to be equal or greater than 1. In our example, the ratio is lower than 1, and as such, the company does not have enough money to make the yearly payments of $6,708.

In this case, the business could benefit from refinancing its current debt by obtaining a loan at a lower interest rate and lower monthly payments. To refinance the existing debt follow this formula: current balance owed + any additional capital + origination fee.

It’s important to note that origination fees — fees charged upfront by a lender to ensure an applicant’s commitment and offset some of the processing costs — may vary between lenders. Typically, these fees are stated as a percentage of loans.

Let’s look at an example:

Current balance owed                   $10,950

+ Any additional capital                 $0

+ Origination fees                            $500

= Total refinance amount             $11,450

The monthly payments on an $11,450 loan, with an interest rate at 10.0% and 3 year termwould be $370.21, or $4,442 annually. Let’s see if the DSCR improves in this case:

DSCR = 6,000/4,442

DSCR = 1.3

A DSCR of 1.3 is a satisfactory ratio for a lender and this request to refinance would be approved.

Additional questions to ask new lenders:

Terms and conditions of loans can vary between lenders.  As a best practice, ask the following questions to the new lender. The information you gather from these questions can highlight whether or not a lender is transparent and trustworthy:

  1. Is the loan short term or long term?
  2. What is the closing fee?
  3. Is the interest rate fixed or variable?
  4. Is there a prepayment penalty?

A refinance should cover loans that have daily/weekly payments, merchant cash advances, factoring, high interest rates and short term debt.  Refinancing your business debt only makes sense if it provides better terms and benefits to the overall financial health of your business,  so make sure to do your math before you start the conversation with the lender.

If you are looking to refinance your existing business debt with a more affordable loan, contact a Pursuit advisor.

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