How banks gauge your business' capacity
When applying for a commercial loan, banks work to match your business with the appropriate amount of debt.
Imagine you’re hauling a load with a vehicle. You want the right vehicle for the job. You can’t pull a semi with a sedan, but at the same time, it’s overkill to tow a go-kart with a monster truck.
You need balance.
The same is true for banks considering whether to approve a business loan. Matching the right amount of debt is vital to making sure both parties are satisfied and repayment is achievable.
We call this capacity. It refers to your business’ ability to repay a loan and how much debt it can theoretically carry based on its savings and active income.
The signifiers of good capacity.
Measuring capacity requires banks to figure out how much your business earns minus the cost of any debts or liabilities. We call this its debt-to-tangible-net-worth-ratio. Higher revenues and lower debts mean a business is more likely to repay a loan.
For example, even if your business generates a large amount of revenue, if those earnings are offset by a lot of outstanding debt or high work-related expenses, it’s less likely that you will be able to secure a loan.
The benefits of balanced capacity.
Businesses, like bodies, need constant and varied sources of nutrition. By investing in a wide variety of areas, you keep your business balanced and you’re more likely to end up with the right amount of capacity.
By spreading your efforts across multiple areas (ex. debt repayment, business expenses, reinvestment in the company), you create a healthier business.
And just like with bodies, there are benefits to keeping your business well-nourished:
- A good balance can demonstrate strong character and a solid foundation for business growth.
- Balance tends to lead to higher capacity, which, in turn, makes securing a loan easier.
Increasing capacity can take many forms.
In the event you find your business needing to improve its capacity, there are some actions you can take:
- Raising outside capital: Raising capital through friends, family, and other methods can improve your business’ debt-to-income ratio.
- Adding partners: Bringing on lenders or partners can spread the load around and lessen individual debt.
- Outside aid: In certain extenuating circumstances – like natural disasters – outside aid (government or state funding, for example) can help boost liquidity.
- Paying down debt: Simply chipping away consistently at existing debt can help get your business back on track if you find yourself in a difficult situation.
“For capacity, when you’re out of whack, it’s hard to get back,” Harrod said. “Sometimes the best thing to do is to chip away until the situation becomes more manageable.”
When it comes to business capacity:
- It’s important to find the right amount of debt for your business.
- Higher revenue and lower debt lead to more capacity.
- Keep it balanced and well-nourished.
- If necessary, work to raise capacity in the way that makes most sense for your situation.
Note: This is one of five blogs breaking down the Four C's and a P of credit worthiness – character, capital, capacity, collateral, and purpose.