The Bank has all your company’s financial statements- what do they do with them? What are they looking for? Why do they need all of them? I often hear from companies when they are turned down that the bank declined due to ratios that didn’t meet the banks minimum standards. Here are the three most important ratios.
First and probably the most likely to cause trouble is called Debt Service Coverage (DSC). It can also be called Fixed Charge Coverage (FCC) or Cash Flow Coverage (CFC), slightly modified versions of DSC. Most of the banks I talk to like debt service to be in the range of 1.15 to 1.25 based on the following equation:
(Net income + interest + depreciation + taxes* + amortization + non-cash expenditures – any dividends paid to owners)/ (Interest + last twelve months principal payments**).
*Taxes are federal income taxes.
**Sometimes instead of last twelve months principal, the bank will do CPLTD (current portion of long term debt, which is the NEXT 12 months of principal). Make sure that they have both numbers.
If there is significant accrued interest rather than cash interest, make sure to let the bank know how much of each as they will want to calculate both ways.
This is the very first ratio a lender looks at since it shows how much cash flow is available to service debt. We use this to find out whether the new debt service can be paid for by historic cash flow. If not, then the next step is to confirm that projected cash flows can service debt (which is when the projections become critical). I highly recommend that you check out these ratios in advance and if the company’s cash flows don’t meet the minimums that you are ready to mitigate that issue with projections or other answers or you’ll be turned down right away.
Next is the balance sheet ratio, Tangible Net Worth (TNW). The usual way to calculate this is as follows:
Total Assets-Total Liabilities- Intangible Assets + Intangible Liabilities, with intangibles including good will, subordinated debt, brands, franchises, trademarks, patents. A business will normally have subordinated debt if a creditor (generally an owner) has agreed that their debt can be subordinate to any bank debt.
Bankers are looking for this to be positive! I know this sounds odd but once all the intangibles are taken out, TNW can often be negative. Then the job of the lender is to mitigate that by explaining what is causing the negative TNW- companies with a lot of goodwill and patents need to show that these are worth “adding back” to the equation in some amount for example. Its best to have this argument ready before you talk to the lender.
Next is a balance sheet ratio called Debt to Worth ratio (often called the Leverage Ratio), it can be calculated several different ways as well. The usual is Total Liabilities/Tangible Net Worth and for this ratio, lenders are looking for a ratio below 3 to 1. This one is pretty easy to calculate since you already have the TNW portion calculated. Total Liabilities is exactly that, although if there is subordinated debt you are allowed to subtract that from total liabilities.
What this tells the bank is that the company is not overleveraged. It is not unusual for this number to be under one for a company that is not growing quickly or one with significant equipment and real estate that doesn’t have significant debt.
An ever larger percentage of companies are leveraged, not because they are in trouble but because they don’t have significant tangible assets- think of professional service companies or software companies. They may have a line of credit or have acquired a competitor so they have loans outstanding offset by goodwill or other intangible assets. Thus a leverage of 3x becomes more reasonable.
These are the three most important ratios to look at when you are contemplating a trip to the bank for money. I would suggest you take a little time to check them out periodically just to make sure of where you are at. There are many others as well, however we’ll leave those for another day.
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