Before applying for a business loan, it’s important to understand some common business loan terms, acronyms, and phrases. This will help you make better financial decisions and understand what a bank or lender will need to approve your business loan. Read this article to better understand some of the common terminology used in business lending.
Business loan glossary
Ability to scale
A business’ ability to adapt and grow while maintaining performance levels is known as the ability to scale. When operational needs increase, a company that scales successfully can maintain or even increase its performance and efficiency, regardless of the circumstances.
Balance sheet optimization
Financial organizations can make better decisions about how to use their assets by optimizing their balance sheets, which enables them to increase profitability and support ongoing growth.
The amount of money a lender is willing to lend a business. A lender’s willingness to lend money to a business is determined by the value of the business and its assets, such as accounts receivable, inventory, and equipment, among others.
A company’s borrowing capacity is the maximum amount of money it may borrow without endangering its ability to repay a loan in full and on time.
Burn rate is the average amount of money a company is losing every month (how quickly a company is “burning” its cash reserves).
Net burn = Monthly cash sales – monthly cash expenses
Business credit score
A business credit score is a measure of a business’ creditworthiness. This score can be used to estimate the level of risk a business is considered to pose when applying for a loan. Although there’s no set industry standard for business credit scores (unlike personal credit scores which adhere to the FICO credit scoring model) business credit score is usually calculated on a scale of 0 to 100, where 0 is a poor credit rating and 100 is an excellent credit rating. A business usually must have a score of 75 or higher to qualify for a small business loan.
The process of deciding how an organization will distribute and invest its financial resources is known as capital allocation.
Cash conversion cycle
The amount of time (measured in days) it takes for a business to convert its investments in inventory and other resources into cash from sales is known as the cash conversion cycle (CCC).
CCC = days of inventory outstanding – days of sales outstanding + days of payables outstanding
Credit risk is the chance of suffering a loss due to a borrower’s failure to make loan payments or meet contractual commitments. While it’s impossible to predict who may miss payments, correctly evaluating and managing credit risk can decrease the impact of a loss.
See “Business credit score” above.
This ratio assesses a company’s ability to sustainably balance its assets, financing, and liabilities by comparing its current assets to its current liabilities. The current ratio typically serves as a broad indicator of a company’s financial health because it demonstrates its capacity to settle short-term debts.
Current ratio = current assets / current liabilities
Customer acquisition cost
Customer acquisition cost (CAC) is the amount of money it takes to gain a new customer. It’s calculated by dividing the amount spent to acquire the new customers by the number of new customers gained. Many online businesses aim for a CAC of $3 or more.
CAC = amount of money spent to acquire new customers / number of new customers gained
Customer lifetime value
Customer lifetime value (LTV) is the amount of money a business expects to earn from a customer over the span of their relationship with the business. A high LTV can be a positive sign, indicating repeat business and possibly increased customer satisfaction.
LTV = customer value x duration of the relationship
Days inventory outstanding
Days inventory outstanding (DIO) is a working capital management ratio that gauges how long an organization typically keeps inventory before selling it. The longer the cash is held in inventory, the greater the chance that the stock may become out-of-date. When it comes to DIO, the lower the number, the shorter this risk is.
Days payable outstanding
Days payable outstanding (DPO) is a financial measure that shows how long, on average (in days), it takes a business to pay its creditors, who could be lenders, vendors, or suppliers.
Days sales outstanding
Days sales outstanding (DSO) is the average number of days it takes to recover an organization’s accounts receivable or convert credit sales into cash.
Earnings before interest and taxes
EBIT (earnings before interest and taxes) is a common accounting term used to describe a company’s operational performance. EBIT excludes income tax and interest costs when defining a company’s net income. It can be calculated using either a “direct” or “indirect” formula. The first is considered a direct definition of EBIT because revenue is adjusted for all relevant expenses. The second formula is known as indirect since it outlines the components that should be included in the net income.
EBIT (Direct method) = revenue – cost of goods sold – operating expenses
EBIT (Indirect method) = net income + income tax expense + interest expenses
Fixed cost burden
Businesses use burden rate calculations to compare direct and indirect expenses and learn more about the total cost of delivering their goods and services.
Gross margin is the amount of money left after all direct costs related to producing or obtaining the goods or services have been subtracted. Gross margin is expressed as a percentage (%).
Gross margin (%) = gross profit / revenue
Key performance indicators
Key performance indicators, or KPIs, are a collection of measures used to assess an organization’s overall long-term performance. Gross margin, LTV, ROAS, and many other business loan terms defined here are examples of important KPIs for online businesses.
Liquidity refers to how quickly you can access your cash. In an emergency or other financial setback, you can access liquidity through your emergency savings account or the cash you have on hand. Liquidity is important as it enables a business to leverage opportunities that require quickly accessing cash, such as making a large inventory purchase or entering a new market or sales channel.
A company’s profitability is determined by how much money it makes compared to how much it spends. More effective businesses will make more money relative to their costs than less effective businesses, which must spend more to make the same amount of money.
Return on ad spend
Return on ad spend, or ROAS, compares income against the cost of advertising campaigns. The calculation’s objective is to assess whether a business’ advertising is effective. The ROAS formula is straightforward. Simply divide your revenue generated from ads by the amount spent on ads. A common goal is a 4:1 ratio ($4 in revenue for every $1 spent on ads).
In business terminology, cash runway refers to the period during which an unprofitable company can continue to operate without raising any new capital. As long as you know the burn rate, calculating the cash runway of a business is straightforward. You only need to divide the cash on hand (a business’ accessible cash) by the burn rate to get your runway.
Runway = Cash on hand / net burn
For example, if a business has $240,000 of cash on hand and has a net burn of $20,000 per month, the business has 12 months of runway.
Working capital is the money a business needs to cover its ongoing expenses. Working capital focuses on two critical components of a business: current assets and current liabilities.
Working capital = current assets – current liabilities
Working capital funding gap
The time it takes for a business to turn its net working capital into revenue is known as the working capital cycle. To maximize cash flow, businesses often try to control this cycle by selling products quickly, collecting customer payments swiftly, and paying debts slowly.