How to Calculate the Loan Amount You Need
Determining the loan amount needed for the business is a great challenge for the SME owners because getting a loan lower than the required will not fulfill the business’s capital needs and getting a loan higher than required will increase the cost of the business unnecessarily. For this, the SMEs should follow a proper guideline to calculate the loan amount needed.
Determine the financing gap:
To find out how much financing is needed for the business, the SMEs should create a budget plan of the business expenses and prepare financial projections of the business including its estimations on revenue and profits. If the earnings of the business are lower than its budget projections, the business can decide on taking a loan to fill up the financing gap.
Determine the purpose of the loan:
The owner of the SME should determine on what purpose, the loaned amount will be used such as purchasing new equipment, developing and launching a new product, increasing business production level, and expanding marketing activities etc. In this way, the business will determine the amount needed. For example, if the business plans to launch a new product it may require a larger amount of loan, but if it needs to buy a new machine, the loan amount can be lower.
Determine how much loan the business can afford:
Based on the estimated financing gap and purpose of the loan, the business needs to determine how much loan the business can afford. In this case, the business owner should assess the debt service coverage ratio (DSCR) and debt-to-income (DTI) ratio to determine whether the cash flow of the business will cover the payment amount of the loan. A higher ratio will indicate that the business can repay the loan amount.
Determine the length of the loan period:
The SME owner needs to determine whether the loan will be short-term, medium, or long-term and assess how long it will take the business to repay the loan amount from positive cash flows over that period. Based on the business profit projection and loan period, the SME can estimate its required loan amount. For example, if the SME requires a 5-year loan and it has a profit and cash flow projection for 5 years, it can take a loan to an amount lower than its projected cash flow, so that loan can be repaid within 5 years.
Determine the cost of the loan:
Based on the loan period, the business owner needs to calculate the total cost of the loan including the loan principal and interest payments. Comparing the loan cost with business profits and cashflows, the business owner can decide how much loan would be appropriate for the business. For example, if the business takes a SR5000 loan for 5 years at a 10% interest rate, the total cost of the loan would be SR8052 (SR5000 and SR3053 profit). Thus, if the business can earn higher than SR8052 during this loan period, it can take a loan of SR5000.
Determine future financing needs:
The business owner needs to assess future financing needs based on the growth plans of the business. If there is a need for near future financing, the business can take short-term loans, otherwise, the business can long-term loans. In this case, if long-term loans are taken, it might be difficult for SMEs to get new loans before existing loans are repaid due to a fall in credit scores. Thus, the SMEs can look for low-cost short-term financing for the business such as invoice financing.
For example, if the SME requires to buy a piece of new equipment for SR300000 and has capital only in the form of an outstanding invoice of SR400000, the business can use invoice financing to buy the new equipment needed for the business. In this case, the SME can have an invoice finance deal with a financial institution to give 80% upfront with a charge of 3%. Thus,
· The total invoice value= SR400000,
· The invoice advanced amount= (SR400000x 80%) =SR320000
· Reserve amount = (SR400000-SR320000) =SR80000
· Invoice fees and charge= (SR400000x 3%) = SR12000.
This way, the SMEs can collect an invoice advance of SR320000 and use it to buy the new equipment. After the customer pays the outstanding invoice, the payment will go to the financial institute. In this case, from the reserved amount, the SME will get (SR80000-SR12000) = SR78000. Thus, based on the service fees rate and reserve rate, the SMEs can calculate the loan amount in invoice financing.
A peer-to-peer (P2P) invoice financing platform in Saudi Arabia is firstly introduced by Lendo which provides low-cost invoice financing services to small and medium-sized enterprises (SMEs). Lendo helps its clients to get urgent business finances through invoice financing and has a lower rate of charges. For detailed information about Lendo and its services click here.