Getting approved for a loan is only half the equation — the more important question is how much debt your business can realistically handle without straining cash flow. Borrowing more than you can comfortably repay is one of the leading causes of small business financial trouble. Here’s how to calculate it properly before you apply.
Step 1: Understand the Debt Service Coverage Ratio (DSCR)
Lenders — and you — should use the Debt Service Coverage Ratio (DSCR) as the primary measure of loan affordability:
DSCR = Net Operating Income ÷ Total Debt Service (annual loan payments)
- A DSCR of 1.0 means your income exactly covers your debt payments, with no cushion.
- A DSCR of 1.25 or higher is generally considered healthy and is what most lenders require for approval.
- A DSCR below 1.0 means your business doesn’t generate enough income to cover the proposed loan payment — a red flag for both you and any lender.
Example
If your business generates $120,000 in annual net operating income, and your existing + proposed debt payments total $80,000 per year:
DSCR = $120,000 ÷ $80,000 = 1.5
This would generally be considered a strong, healthy ratio.
Step 2: Calculate Your Free Cash Flow
Beyond DSCR, look at your free cash flow — what’s left after covering all operating expenses, existing debt payments, and a reasonable owner’s draw. This is the actual cushion available to absorb a new loan payment, seasonal downturns, or unexpected costs.
Free Cash Flow = Net Income + Depreciation/Amortization − Owner’s Draw − Existing Debt Payments
If your free cash flow, after adding a new loan payment, still leaves a healthy buffer (ideally 15–20% or more of monthly revenue), the loan is likely affordable.
Step 3: Estimate the Monthly Payment Before You Apply
You don’t need to wait for a lender’s offer to estimate your payment. Use this simplified formula for a fixed-rate term loan:
Monthly Payment = [P × r × (1 + r)^n] ÷ [(1 + r)^n − 1]
Where:
- P = loan amount (principal)
- r = monthly interest rate (annual rate ÷ 12)
- n = number of monthly payments (loan term in months)
Example
A $100,000 loan at 9% annual interest over 5 years (60 months):
- r = 0.09 ÷ 12 = 0.0075
- Monthly payment ≈ $2,076
- Total repaid over 5 years ≈ $124,560
Most online lenders and bank websites also offer free loan payment calculators that do this math for you — useful for quickly comparing offers with different rates and terms.
Step 4: Stress-Test Your Numbers
Before committing, ask: could my business still make this payment during a slow month or a seasonal dip? If a 20–30% drop in revenue would make the loan payment unmanageable, consider a smaller loan amount, a longer term (to lower the monthly payment), or a more flexible product like a line of credit instead of a fixed-payment term loan.
Warning Signs You’re Borrowing Too Much
- Your DSCR is below 1.15–1.25 even under normal (non-stressed) conditions.
- The new loan payment would exceed 15–20% of your average monthly revenue.
- You’d need to significantly cut owner’s draw or reinvestment just to cover payments.
- You’re borrowing to cover recurring operating losses rather than funding growth or a specific investment.
Frequently Asked Questions
What DSCR do lenders typically require? Most banks and SBA lenders look for a DSCR of at least 1.25, though some online lenders may accept slightly lower ratios in exchange for higher rates.
Is it better to choose a longer loan term to lower my payment? A longer term reduces your monthly payment but increases the total interest paid over the life of the loan. It can make sense if it improves cash flow safety, but shouldn’t be used simply to justify borrowing more than needed.
Should I include my full revenue or just profit in this calculation? Use net operating income (profit before debt payments), not total revenue — total revenue doesn’t account for your operating expenses and will overstate what you can actually afford to repay.
Conclusion
Before signing any loan agreement, run the numbers yourself using your DSCR and free cash flow — don’t rely solely on what a lender is willing to approve you for, since approval amounts don’t always reflect what’s truly sustainable for your business. For guidance on the types of financing available once you know your budget, see our guide on [what is a small business loan and how does it work].