Most small businesses are financed using a combination of personal resources and borrowed funds, meaning that understanding the mechanics behind loans should be a priority for entrepreneurs. This is particularly true because the implications of finance and financial terms tend to be opaque even when they aren’t being obscured behind dense language and byzantine rules.
Here are five loan terms that small business owners must know before taking out loans:
Debt to Income Ratio
As its name indicates, the debt to income ratio is the percentage of the business’s gross income that goes towards paying its short-term debt obligations. For obvious reasons, a ratio of one or higher is somewhere between disastrous and catastrophic because it indicates that the business is not earning enough money to even cover the minimum payments on its debts, much less its other operating and miscellaneous expenses. In general, lenders prefer businesses with smaller debt to income ratios over businesses with simply high incomes because the latter is less useful as a measurement of the business’s ability to repay its debts.
The structure of a loan is composed of the rules by which that loan operates and is repaid. Structure has significant influence in the risk of the loan and thus the interest rates that lenders will charge businesses. For example, a secured loan usually charges less interest than an unsecured loan because loans are secured by designating certain assets as collateral to be seized should the borrower default on the loan. The lender can afford to charge lower interest rates because its losses are diminished compared to the unsecured loan in case of default.
Interest rate is the percentage of the principal that is charged as interest in each time period. Although most interest rates tend to be quoted on an annual basis, those rates can be misleading because they tend to be nominal rates rather than effective rates. For example, an 8% interest rate compounded on a semi-annual basis means that the principal is charged interest at 4% every six months, meaning that the effective annual interest rate is actually 8.16%. Businesses must carefully read the conditions on their loans and then run their own calculations to figure the actual amounts that they’ll be paying each period for the privilege of borrowing money.
The principal is the sum that the business borrows from its lenders. It is one of the two figures that is used to calculate the loan’s periodic interest. Most loans calculate interest based on the current amount of principal rather than the original amount, meaning that the repayment of the loan speeds up as time passes. This is because a larger portion of the earlier periodic payment goes towards satisfying interest instead of principal compared to later payments.
Solvency is the ability of the business to meet its short-term debt obligations as they become due. It is important to remember that solvency is not the same as profitability. A business can produce a profit by earning more revenues than expenses incurred, but that means little for their solvency unless those revenues are collected in cash. This is because most businesses permit the recording of most revenues and expenses before the corresponding cash transactions have taken place. As a result, the solvency of most businesses is more easily gauged using their cash flow statement than their income statement.
This guest post was contributed by Darren Bechard, a freelance writer and business finance researcher. He mainly writes about business finance and enjoys sharing his tips and insights on numerous blogs. Visit Wongaforbusiness.com for more business finance options.