# How much can I borrow for my business?

The short answer is: You should ask for an amount that you can afford to repay, including interest, without undue financial stress. The calculation is fairly straightforward, but the theory behind it could use some unpacking.

A super simplified way to understand your borrowing capacity is to add your business’s annual net income (profit) to its depreciation expenses and make sure the total is enough to cover the loan payments.

But that’s a crude approach, says Nigel Robertson, Senior Advisor, Client Retention at BDC. In reality, most banks will calculate what’s known as your fixed charge coverage ratio (FCCR), which is a measure of solvency that looks at additional variables to offer a more nuanced view.

By learning how to calculate the FCCR yourself, not only will you be better prepared for your bank appointment—you will have a much more accurate idea of how much your business can comfortably borrow.

## Doing the math

Like the simplified approach, the FCCR calculation includes your business’s earnings, but all banks will use EBITDA rather than just net earnings, says Robertson.

## Understanding EBITDA

EBITDA stands for earnings before interest, taxes, depreciation and amortization. It can offer a detailed picture of a company’s operational profitability and performance, and is a common metric for comparing companies within the same industry or assessing a company's ability to generate cash from operations.

EBITDA = net profit + interest + taxes + depreciation and amortization

In this context:

• Net income is your profit after deducting all expenses.
• Interest is the cost of the company’s debt. Adding it back offers a clearer picture of operational profitability, since interest expenses can vary widely depending on a company’s financing structure.
• Depreciation and amortization spread the cost of an item out over its useful life. “Depreciation” is the term used to describe physical assets (like equipment and buildings), while “amortization” refers to intangible assets (like patents). For example, if you buy a piece of equipment for \$500,000, you wouldn’t expense that whole amount in the first year, because that would make the year look unprofitable. You would depreciate it over five years because it delivers value over that entire time period.

Robertson says EBITDA “brings us closer to understanding your business’s cash flow,” so is better than just net earnings when it comes to loan calculations.

“Looking solely at net profit or earnings would understate how much the business could afford to pay—because effectively, the depreciation and amortization amounts are still in the business.”

## How to calculate FCCR

Many banks will calculate FCCR using some variation of the following formula:

(EBITDA - Unfunded CapEx - Taxes) / (Cash interest expense + Mandatory debt repayment )  =  FCCR

In the above equation:

• CapEx stands for unfinanced capital expenditures, which are the funds used by a business to acquire, upgrade and maintain physical assets, such as buildings or equipment.
• Taxes are the total amount of taxes paid by the business.
• Cash interest expense reflects the business’s cash spending on interest payments for the business's debt.
• Mandatory debt repayment reflects the required repayments of the principal on the business's debt.

Different banks may use slightly different definitions of FCCR, so you may see nuances in the calculation depending on where you look or who you ask. For example, some may adjust your EBITDA by adding or subtracting extraordinary items or gains or losses on asset sales, or by deducting rent. Many, like BDC, will also deduct dividends (if applicable) from your EBITDA.

Regardless, most banks will want to see an FCCR of at least 1.25, says Robertson.

## FCCR calculation example

Suppose you want to borrow \$100,000 and pay it back within five years, and the interest rate will be 8%.
If your EBITDA is \$55,000, but you have \$10,000 in unfinanced capital expenditures and \$2,000 in tax bills, then you have \$43,000 as the numerator in the above equation.

Looking at the denominator, the 8% annual interest on \$100,000 would be \$8,000. That means that in the first year of the loan period, you would need to repay \$20,000 in principal (\$100,000 ÷ 5 years) and \$8,000 in interest, for a total of \$28,000. (You would pay slightly less interest per year after that as the principal gets paid down.)

Dividing \$43,000 by \$28,000 yields an FCCR of 1.54.

The calculation looks like this:

(\$55,000 - \$10,000 - \$2,000) / (\$20,000 + \$8,000 )  =  1.54

Because the FCCR is higher than 1.25, it’s favourable—so a bank would likely conclude that you can afford to borrow the requested \$100,000.

Conversely, if your EBITDA was \$45,000, but all other figures were the same, then your FCCR would work out to 1.17—a little short of ideal.

If you want to try plugging in different numbers—whether to prepare for a bank appointment or plan for a future loan—you could set up a spreadsheet with a formula designed to solve for FCCR, suggests Robertson.

“A spreadsheet set up with a formula could let you ‘audition’ a loan amount. If the ratio is too low, you can try other amounts.”

## How does the cash flow cycle influence your borrowing capacity?

Remember that an irregular cash flow can affect your borrowing capacity, says Robertson.

For example, if your business sells a health product that people use steadily, year-round, then you may have relatively stable earnings from month to month. If you need \$5,000 every month to repay a business loan, and you can always expect to make enough to cover that, you’re in good shape.

However, some businesses are more cyclical. To take an extreme example, if you were in the business of growing, tending, harvesting and selling Christmas trees, and you earned almost all your income in the month of December, you might be short of the earnings needed for your loan payments in the other months unless you set some funds aside.

“In this way, your operating cycle can introduce timing issues even if overall, your business is earning enough money to make the loan payments,” says Robertson.

Some banks may offer loans where monthly payment amounts can fluctuate. Otherwise, plan ahead to make sure you have the needed liquidity.

## What if my business is new?

But what if you just launched your start-up seven months ago, so there are no historical financial results that you (or the bank) can use to make the FCCR?

Not to worry: Banks can look at other factors. For example, if you’re the founder, they might look at your personal credit score as a measure of the likelihood that you’ll make every effort to repay the loan. Or they might ask you to provide forecasts of some of the required figures—not so much to make the calculation as to see how capable you are of making informed forecasts.

You can prepare for your ask—and make sure you’ll be able to manage the loan payments—by making your own careful forecasts and plugging the numbers into the FCCR equation.

## What if I’m offered more money?

If your financials are excellent, you may find yourself in a position where a bank offers to lend you more money than you had in mind.

Don’t take it, says Robertson.

“If you borrow more than you need, you have just introduced an additional burden on your business in the form of a contractual obligation,” he says. “Instead, ask yourself how much you need and why. What are you going to accomplish with this money?”

That said, it’s also important not to underestimate your financing needs, because doing so could leave you facing a cash crunch. Be sure to calculate your cash flow before finalizing any loan agreement.