Commercial lending is more of an art than a science, and although the underwriting process may appear confusing, it is not the mystery that it may seem to be. Rather, it is simply a process of gathering company information, analyzing financial data, and making informed judgments.
Banks operate on very thin margins, are highly regulated, and lend depositor and shareholder money. Consequently, there is little room for write-offs of bad loans. To assist in assessing the viability of a commercial loan, lenders calculate various ratios to monitor a business and its ability to repay a loan. Lenders use ratio analysis as a tool to quantitatively understand and measure a business’s performance, as it is a method by which a company’s operations can be evaluated using the balance sheet, income statement, and statement of cash flows.
While there are many financial ratios that may be calculated and evaluated, three of the more important ratios in a commercial loan transaction are:
- Debt-to-Cash Flow Ratio (typically called the Leverage Ratio),
- Debt Service Coverage Ratio, and
- Quick Ratio.
The debt-to-cash flow ratio or leverage ratio measures the number of years of cash flow it will take for the borrower to retire the debt, and is calculated by dividing the borrower’s debt by its cash flow. The leverage ratio is applicable and important across almost any lending sector. A lower number is more attractive to the lender.
Similar to the leverage ratio is the debt service coverage ratio (DSCR), which is a common financial covenant in many credit facilities. The DSCR measures a company’s ability to service its current debts by comparing its net income with its total debt service obligations. To calculate the DSCR, net operating income is divided by the total debt service. There is latitude in which items (e.g., EBITDA, EBITDAR, capital leases, guarantees, etc.) are included in the ratio. Lenders may look for a DSCR of 1.25 or more as the higher the ratio, the greater the ability of the borrower to repay the loan.
The quick ratio, also called the acid test ratio, is a liquidity ratio that measures the ability of a company to pay its current liabilities when they come due with only quick assets. Quick assets are current assets that can be converted to cash in the short-term (typically within 90 days). Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets. If a company has enough quick assets to cover its total current liabilities, the company more likely will be able to pay off its obligations without having to sell any long-term or capital assets.
Ratio analysis is a useful tool to facilitate the identification of trends and provides a practical way to compare a business to others in its industry. Management should incorporate relevant ratios in its regular financial and operational reviews of the business.
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