How to Think Like a CFO: Calculating Your Business’s Capability For Debt Financing
Updated: Dec 18, 2021
For most companies' female founders and CEOs, the thought of borrowing money is terrifying. This attitude creates an aversion to debt financing because there’s a preconception that owing money is a terrible thing. Paired with the possibility of failure, it becomes a full-fledged horror story that might have you running away from the mere mention of debt.
In this episode, we discuss the calculations you need to do to assess if your business can afford debt financing. Debt doesn't have to be a scary thing! Realistically, if you own a business, you most likely have business debt. With the right mindset, you can make proactive decisions that use debt as financial leverage in expanding your business.
Debt financing CAN work for the right stage of business and if you plan properly! Do you want to know how you can prepare your business to raise funds through debt financing? Tune in to this episode to learn more!
Here are three reasons why you should listen to the full episode:
Find out more about business debt and debt financing.
Learn how to think like a lender.
Discover the key things you must consider before taking on debt financing.
Debt Financing Resources:
Visit Christina Sjahli’s website for related episodes on the Her CEO Journey™ Podcast.
Understand whether your needs fall under long term debt financing or short term debt financing with the previous episode of Her CFO Tips:
Chat with Christina and set up a time here!
Download the Debt Service Coverage Ratio Calculator, so you can see if your business can handle debt!
Business Debt and Debt Financing
Regardless of whether or not you use debt financing, you probably already have business debt. Purchased goods and services that aren't paid for immediately are technically considered short-term debt financing.
Debt financing is a great way to build your company, get valuable working capital, and grow your small business. But to do debt financing, you need to take a proactive approach and learn about the best type of debt financing and debt capital for your enterprise.
Finally, it’s crucial to assess if your business can afford debt financing. Doing this requires being aware of how to think like a lender before even approaching one.
Debt Financing Tip #1: Know Your Debt Service Coverage Ratio
The debt service coverage ratio measures the relationship between your business income and debt if you have any. It helps you determine whether or not your business can afford to pay your loan, including its principal, interest, and fees.
Be careful with additional fees. You don’t want a debt service coverage ratio lower than one. At one, your business is at the breakeven point — this means that you have enough income to pay your monthly payments and interest payments. However, you won't have any profit.
If you don’t make a profit, you might get stuck in a cycle of needing business loans over and over again. To eliminate reliance on debt financing, try to aim for a debt coverage ratio of 1.25 or higher.
Debt Financing Tip #2: Calculate Your Business Debt-to-Income Ratio
The business debt-to-income ratio compares the amount of debt payment each month to your business's monthly revenue. The lower the percentage, the better you can afford to take on new debt financing. On the safe side, try to go for a debt-to-income ratio lower than 36%.
Once you’ve cleared the conditions for the debt service coverage and debt-to-income ratios, you can proceed to the next step in the lender’s toolbox.
Debt Financing Tip #3: Assess Your Loan Repayment Plan
The third tool in the lender’s toolbox is assessing how you plan on repaying your debt. Paying back your loan will cut into your business cash flow — a fact that your lender is very much aware of.
If you’re using this loan to resolve cash flow problems, the lender will want to make sure that this new debt financing doesn’t present more issues for you in the long run.
The Importance of a Financial Forecast in Debt Financing
After assessing debt payment, financial forecasting will come into play. Your ratios might look great, but it's futile without putting those numbers into a forecast. Doing so will let you know if you can really afford this new debt financing. Taking on a loan without a business plan for paying it back will likely harm your business.
Once you have a financial forecast, you should take the time to review and compare it with your business's actual performance. Otherwise, it would be a useless tool.
If there is any indication that your business can’t afford the loan repayment, then transparency and communication with the lender are crucial. This enables them to come up with a plan to help your business.
Final Thoughts on Debt Financing
I want to make sure that you are making proactive, strategic business decisions. Here are some guide questions to help you know if you are ready for debt financing:
Is the business debt service coverage ratio 1.25 or above?
Is the business debt-to-income ratio lower than 36%?
Do you have business assets that can serve as valuable collateral?
As the founder and CEO, are you ready to provide personal assets?
Will this debt financing help grow your business and be a valuable investment?
Does the business forecast show that you have a clear ability to repay the loan on time?
Have you compared the different financing options and considered short-term versus long-term capital?
Have you taken the costs of debt financing, such as origination fees, contract fees, administration fees, or early repayment fees, into account?
Remember, as the CEO and founder of your small business, you are personally responsible for repaying your loan. So, make sure not to take on too much debt. Now that you have these key takeaways on debt financing, you can be more well-equipped to borrow money for your day to day operations.
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Having financial distress as a small business owner? Angel investors and equity financing aren’t your only options. With debt financing, you can secure your capital needs without giving away business ownership.
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Christina Sjahli: Taking on debt as a financing strategy for your business can be a scary thing, especially for female founders. We are more likely to feel scared about taking debt financing maybe because we were told that owing money is terrible. That's what my parents told me. Perhaps your upbringing is similar to mine. As a result, we think getting a loan, getting into debt is terrible, especially if we think we are going to fail and cannot pay it back.
I get it. This is why I feel compelled to curate this solo episode on how to assess if your business can afford debt financing, so you won't feel scared and you know, you can pay it back.
You're listening to Her CEO Journey, the business finance podcast for mission-driven women entrepreneurs. I'm your host, Christina Sjahli. If you are new here, a big warm welcome. If we are not connected on LinkedIn, please reach out and say hi, because that's where I hang out and share my business finance tips.
If you have been listening to this podcast for a while, and you are a regular listener, I want you to know, I appreciate you. My podcast won't be around without your support. This is a free weekly show where my guests and I want to inspires you to balance between mission and profit, to create an impact in this world, and to achieve financial equality through your business for good.
The reality is, if you are running a business, you already have business debt. Let me give you an example. If you purchase goods or services from suppliers, they send you invoices, right? But you don't pay them right away. Instead, you wait until 15 days, 30 days, or even 45 days.
Technically, during the 15, 30, or even 45 days, your business owes money to the suppliers. That is considered unsecure business debt. The difference is, in this situation, it is a very short-term debt financing strategy.
Business debt finance can be a great way to build out your company, get valuable capital, and invest in areas that can lead to overall growth. But it is only a good idea to take out money when you are taking a proactive approach, research and plan on the best type of debt financing, and understand how working capital works.
We have interviewed of few female founders that choose debt financing over equity financing. Check out the link in the show notes to Episode 124 and 126 and listen to how these mission-driven female founders use debt financing to grow their businesses.
So how can you assess if your business can afford debt financing? Let me show you how to think like a lender before you even approach a lender. Here's how to think like a lender.
Number one, you need to calculate the debt service coverage ratio, which measures the relationship between your business income and its debt, if you have any debt at this moment. It answer the question: Can your business afford to make payments on a loan's principal, interest and fees?
Yes. In addition to interest, sometimes there are additional fees. So you need to be careful. You want a debt service coverage ratio higher than one, and you do not want anything lower than one. Because at one, it means your business has enough income to pay your debt, but there is no profit. Your business is only at the breakeven point.
Can your business afford not to make any profit? If you don't make a profit, you may continue in a hamster wheel of getting financing again and again. And we wouldn't suggest that. It's very tiring to go out there over and over again to get financing. So try to go for a debt service coverage ratio of 1.25 or above.
In order for you to calculate the debt service coverage ratio, there is a calculator you can use, and you can find a link to this calculator in the show notes.
The second tool you need to think like a lender is another calculation. This time you need to calculate your business debt-to-income ratio. This ratio compares the amount of debt payment each month to the amount of revenue your business generate each month.
For the debt-to-income ratio, you want a lower percentage. The lower the percentage means you can afford to take a new debt financing. So try to go for a debt-to-income ratio lower than 36% to be on the safe side.
Assuming your debt service coverage ratio and debt-to-income ratio look great and seems you can afford this new debt financing you are considering, what is next in the lender's toolbox?
The third tool in the lender toolbox is to assess how you plan to repay the debt. Remember, paying back the debt will cut into your business cash flow, and the lender knows this. So if you are using the debt to solve cash flow problems, they want to make sure that this loan, this new debt financing won't put you worse off in the long run.
This is where financial forecasting comes into play. You can have all the ratio looks great. But without having to put the numbers into a forecast, you have no way of knowing if you can really afford this new debt financing. Taking a debt without a plan to repay it, how much you can actually afford to pay, and how does your business looks like after take on the debt is a dangerous game to play.
Once you create a forecast, you also need to take time to review and compare it to the actual performance. So if there is any indication your business cannot afford the debt repayment in the future, then you can be transparent and communicate it right away to the lender. Believe it or not, being transparent allows the lender to figure out a way to help your business.
Creating a forecast but not taking the time to review and compare it to the actual performance? Then really the forecast becomes a useless tool.
We want to make sure you are taking proactive and strategic business decision. So here are some final thoughts to guide you.
Number one, does the business debt service coverage ratio is 1.25 or above?
Number two, does the business debt-to-income ratio is lower than 36%?
Number three, does the business have valuable collateral? Or am I, as the founder and CEO, ready to provide a personal guarantee?
Number four, would this debt financing help to grow your business and be a valuable return on investment instead of putting your business in a financially worse off place?
Number five, does the business forecast show clarity the business has the ability to pay the debt financing back in a timely manner?
Number six, have you compared different financing option and consider short-term versus long-term capital? If you are not certain on the differences between short-term versus long-term capital, go back and listen to Episode 134. The link to this particular episode is in the show notes.
And number seven, have you taken into account the cost of financing? For example, origination fees, contract fees, administration fees, or early repayment fees.
If you are uncertain how much debt your business can handle or how can you create a forecast to include the debt financing repayment, we are here to support you. We understand what you love is to continue expanding your business. You want to focus on building. Forecasting can take time and accountability to maintain. Connect with us at christinasjahli.com/lets-chat.
And that's bring us to the end of another show. Thank you so much for listening to another episode of Her CEO Journey, the business finance podcast for women entrepreneurs. If you want to create a proactive financial plan and process for your business so you are ready to weather the financial storm over the next few months, let's chat and see what's possible for you. Book in a time to speak with me at christinasjahli.com/lets-chat.