Understanding the Business Lending Ratios Your Bank Cares About
For a business seeking a loan, having an understanding of these ratios before applying can be helpful. The most common ratios are Debt Service Coverage Ratios, Working Capital, AP and AR Turn Days, and Gross Profit Margin vs Net Profit Margin. Here’s an explanation of what each of these are and how they impact a lender’s perception of your ability to repay a loan.
Debt Service Coverage Ratio (DSCR)
Lenders need to have an understanding of how much debt a company is carrying before they agree to another loan. This ratio is reached by taking the total amount of the business’s net cash flow and dividing it by the total amount of payments which are required on all outstanding debt. Typically, a DSCR of at least 1.25 is preferable to most lenders. The reason for this is that the higher the DSCR, the greater the likelihood a business can pay their obligations.
DSCR is important for a number of reasons. Lenders feel confident about loaning funds to a business owner who maintains a safe level of debt versus their overall net operating cash flow. This shows good financial management, and a stronger likelihood the business will continue to grow and thrive. The larger the DSCR, the greater cash flow cushion the business has available to navigate any unexpected financial expenses.
Having too little working capital can cause a lender to shy away from approving a loan. However, too much working capital could also raise red flags. One of the reasons having too much working capital on hand can be a red flag is it may indicate to a lender that you are not investing in your company’s growth.
Having too little working capital is problematic for a number of reasons including:
- Insufficient capital in the event of a business slowdown to pay ordinary expenses
- Lack of attention to accounts payable and receivable aging
- Insufficient capital in the event there is a need to replace equipment
Every business sector has different working capital requirements. Lenders will take into consideration the business you are in before determining if you have too little, or too much on hand. This will help shape their lending decisions.
AR and AP Turn Days
When you are managing your accounts receivables (AR) properly, you will have steady cash flow. This will also help you manage your accounts payable (AP) as well. The longer it takes a company to collect their receivables, the less cash they have on hand for operating expenses..
Recent statistics show that over half of businesses receive late payments from customers. Many companies expect to write off one and a half percent of their outstanding accounts receivable as bad debt. While most businesses have a 30-day payment history, more companies collect amounts owed in 34 days or more.
When your business is suffering delays in being paid for services or products delivered, it could potentially create a situation where you are paying your vendors late. Lenders want to see a good balance of collections and timely payments.
Gross Profit Margin Versus Net Profit Margin
When a business deducts the cost of goods sold from their profit, it provides a gross profit margin. However, in order to obtain a net profit margin, the business must deduct all expenses associated with creating their product or service.
Net profit margin is one of the most important ratios which a lender takes into consideration prior to approving a loan application. Before a lender can determine if you are able to pay your outstanding debts, you must have a sufficient amount of money left after your expenses are paid in full.
Lenders will typically ask for a minimum of three years of company financials in addition to the current year-to-date statements. This is because they are looking for financial trends of a company. Knowing that all businesses will have good years and bad years, analyzing multiple years will help the lender better understand the overall health of your company.
Baker Boyer Business Advisors Are Here to Help
When your business is looking for financing, the last thing you want to worry about is how your application will be viewed by the lender. One of the advantages of working with Baker Boyer Business Advisors is we have more than 15 decades of experience helping business owners in various fields secure the financing they need.
Not every type of loan is right for every business. At Baker Boyer, our Business Advisors will evaluate your current financial situation, your long-term business goals, determine your capital needs, and help you find the right type of loan to meet your needs. You can reach us by filling out the Let’s Talk form below.
If you're interested in learning more, please fill out the form below: