As a business owner, it can be helpful to know how a bank operates and thinks when applying for commercial debt. Among other items, certain financial ratios play a key part in determining approval or denial. Let’s discuss some key terms first. A proxy for cash flow that banks use is the term EBITDA or Earnings before Interest, Taxes, Depreciation, adn Amortization. To keep the idea basic, this calculation is a decent measure of a company’s cash flow prior before any accounting for debt. To arrive at this number, you simply take your Net Income and add back those figures to arrive at the number (other non-cash expenses can be included, but for smaller companies these are less typical).
The first ratio we’ll discuss is the Debt Service Coverage Ratio. This ratio is simply a company’s year-end EBITDA divided by a company’s Principal and Interest payments for that year. For new debt, the ratio would be your last year’s EBITDA divided by the projected 12-months of Principal and Interest payments on the new debt. A bank typically likes to see a ratio of 1.25x to be comfortable with your loan and with your performance. Let’s look at an example. Your company generated $200,000 of net income as of 12/31/21, you paid $10,000 in interest, $0 in taxes (because they flow to your personal return), $40,000 in Depreciation (equipemnt and building), and $0 in amortization, which totals an EBITDA of $250,000. Let’s say you would like to purchase a new building for $600,000 and pay off your existing mortgage as your need more space to expand your business. The bank offers you a 5 year term loan on a 15-year mortgage at a 6% interest rate. Your monthly payment would be around $5,064 for 15 years. Does that meet that bank’s criteria? Absolutely, your EBITDA of $150,000 divided by ($5,064×12) $60,768 = 4.11, which basically means your annual cash flow can cover the new debt by over 4 times, well within comfort levels.
Another ratio of typical important is the Total Debt to EBITDA ratio, which is as simple as it sounds. It is the total amount of bank debt outstanding, divided by the prior year’s EBITDA. Using our previous example, we would take $600,000 and divide by $250,000, thereby giving us a Leverage Ratio of 2.5x. Typically banks would like to see this number under 3x but this can vary by industry, company size, history, etc. Obviously, there are numerous other variables that play key parts in loan approval; however, if your EBITDA drops significantly after a challengin year, having your Debt Service Coverage ratio drop below 1x will present significant challenges for you with banks.
A final note, with smaller companies, an owner’s salary/distributions will be added to the company’s Net Income, if the owner typically takes most of the money out of the company. However, personal debts and expenses will also added back to the calculation. This creates more of a “global” cash flow analysis, when the company and the owner are more indistinguishable.
MintFi can provide you with this analysis as well as guidance on whether you will be approved as well as your debt capacity and debt options. If your company is not quite ready for the new debt you might be seeking, MintFi’s experts will provide you with actionable steps to prepare your company to achieve that profitability and cash flow.