When Do Banks Want to See ROI on Business Loans?

Banks make money by lending out deposited funds.

Banks want to see a return on investment on business loans as soon as possible. When that answer doesn't work and a more precise one is requested the answer depends on the payback period. Payback period answers the question: How long does it take to payoff a business loan. Ultimately, this depends on the cash flows created from the business or project in which the loan is funding.

Corporate Finance

Corporate finance is the study of project finance. It helps companies to compare the financial viability of different projects by using different financial metrics and ratios to determine company cash flows and the amount of time it will take a company to pay back a loan. For this, bankers use a financial metric referred to as the payback period.

Payback Period

The payback period tells the banker or project manager how long it will take to recoup the investment in funds. For a banker or lender this means the amount of time before you pay off the loan and for project manager it means the amount of time it takes before all investment funds are paid off. This means that the bank and the project manager usually have the same goals.

Calculation

The payback period is calculated by dividing the business loan by the cumulative cash flows over the life of the loan. When cumulative cash flows equal the loan amount the bank expects to see an ROI. For instance, if you borrowed $100,000 for a project that will pay out $10,000 every month, the bank will expect to see a profit (ROI) in 10 months.

Changing Payback Period

Several factors can influence the time in which banks want to see an ROI for invested capital. If you can provide collateral such as real estate or market securities the bank may increase the payback period. The bank may also increase your payback period if the cash flows from your business are not as ambitious as projections. Lenders usually allow for a certain amount of leeway in sales and income projections.

References

• Solution Matrix: Payback Period; Marty J.Schmidt