One of the most common questions that Business Owners have when getting a loan is “My business made a loss, how am I going to get a loan?”. I am going to explain why recording an accounting loss doesn’t automatically rule you out of applying for a loan.
You may have recorded a loss on your business’ Profit & Loss Statements and thought to yourself – the bank is going to use this against me, how am I ever going to get a loan?
Perhaps this loss was intentional to lower your taxes in the business that year. You may have felt like you had a strong year financially. That’s why you decided to renovate your warehouse, launch that expensive marketing campaign or even purchase a delivery truck. As the business owner, you made an investment decision to spent the extra money and so you recorded an accounting loss.
How does the bank read my financials when deciding to lend me money?
Generating a loss on your financial statements, doesn’t automatically mean you can’t get a loan.
This is because an Accounting Loss is not the same as the underlying cash flow your business might be generating, and that can be used to service a loan. In other words, a paper loss, may not be the same as the true income that your business is earning.
It is important to recognise this so you don’t rule yourself out too quickly from applying for a loan, and instead seek help to analyse your financial statements and present them in the right way to get your loan approved. This area is where an experienced finance broker can assist you, as a business owner, through to getting a loan approved.
What figures is the bank looking for when assessing my loan application?
When deciding if you can afford a loan, the income that your bank is trying to identify is the recurring SURPLUS cash flow that can be relied on year after year to maintain interest or pay down debt.
This is otherwise known as your “Normalised Earnings, Adjusted Earnings Before Interest Tax Depreciation and Amortisation or Adjusted-EBITDA, or simply your Servicing Income.”
To get to this figure, we need to apply what lenders call ADD BACKS to an accounting loss. To understand how Add Backs work, let’s go through an example. Imagine the following Profit & Loss Statement:
- Sales – $800,000
- Gross Profit – $500,000
- Operating expenses – $520,000
- Net Profit Before Tax (“NPBT”) – $20,000 (loss)
- For simplicity, assume this company has no debt, and thus no interest expense.
In the context of this P&L Statement, an Add-Back is any Business Expense that is added to your Net Profit Before Tax to derive your income for loan servicing. Let’s look at three key types.
Add Back 1 – Director’s Salary
This one is hopefully easy to understand. As the owner of the business, you can decide (i) how much of a salary to pay yourself, and (ii) the money is being paid from your business directly to you, so it remains in your control even though it has ‘left’ the business as an expense.
Because of these elements of discretion and control, a bank allows you add back a Director’s Salary to the Net Profit Before Tax and it apply it to loan servicing.
Add Back 2 – Depreciation
Depreciation is an Add Back that is based on the accounting concepts of “Accrual Accounting” and the “Matching Principle”. Put together, this simply means that a business should only recognise an expense in its P&L statement in the same period that corresponding revenue is generated.
For example, your company may pay for a piece of expensive equipment today, but will only realise the benefits of the equipment over many years.
Depreciation is an expense which allocates the cost of that equipment over multiple years as it is being used up. However, because you have already paid for the equipment at the outset, there is no longer any cash being used when you record a depreciation expense each year.
This makes depreciation an “Add Back” for calculating your servicing income.
Add Back 3 – One-Off Expenses
One-Off Expenses are typically large expenses that are non-recurring in nature, and not typical in the normal year-to-year operations of your business. Some examples include:
- Large Fit Outs or Renovations
- Large Asset Purchases
- New Business Set Up Costs
- Marketing Costs to launch a New Product or Service
- Building a Brand New Website
- Specialised Recruitment
- Hiring Specialised Consultants
- Education Expenses to Upskill or Reskill.
They are Added Back to an Accounting Loss because they have temporarily decreased your earnings, and are not representative of your business’ normal cost structure.
How does the bank calculate Add Backs?
In the above example, let’s say for a NPBT of -$20,000, as we look deeper into operating expenses we find we have these add backs:
- Director’s Salary – $120,000
- Depreciation $30,000
- One-Off Upgrade to Existing Premises $100,000
TOTAL Add Backs – $250,000
In this case, your income rises from the -$20,000 you first thought the bank would use to $230,000, which is a much higher figure and is more likely to get you somewhere meaningful in your borrowing goals.
If you have any questions or comments on this topic, you are more than welcome to get in touch with me () or our broking team.
For more information about how to get a home loan approved as a business owner, refer to our earlier piece – “As a Business Owner, What is the Best Time to Apply for a Loan?“
Thank you for reading!