Business Insights: Understanding the Basic Ratios to Securing Business Credit

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Whether your business is a pre-revenue start-up or a middle market-sized company, regardless of industry including from software to energy to healthcare, do you have at least monthly discussions with two or more business or commercial bankers? If you are not, you may well be missing conversations you should be having, including:

  • what qualifies a business for bank financing, if not now then later when the business is producing revenues and/or has a balance sheet and an income statement that is “bankable”
  • the intensifying competition between banks to make commercial and industrial (“C&I”) loans, spurred not only by their experience with real estate lending since the Great Recession struck but also by regulators
  • how the banks are approaching making C&I loans to businesses which had bankable financials before the Great Recession, took a hit during the downturn, and now are coming back as the economy recovers

In terms of qualifying for bank financing, each bank has developed its own set of metrics, often referred to as ratios, and to some extent its own terms to describe those ratios. A straightforward way to categorize and describe the various ratios is by the three different time-frames they measure:

  1. a “snapshot” measurement of cash flow: sometimes called a debt service coverage ratio (“DSCR”) where earnings before interest, depreciation, and amortization (“EBIDA”) are divided by the sum of the loan principal and interest expense to be paid in the period, or other times called the fixed cost charge ratio, where revenue is divided by recurring costs including financing but also lease payments and other periodic fixed costs – generally banks are looking for cash flow ratios of about 1.2x or better
  2. a medium-term measurement of liquidity, usually taking current assets (meaning assets which can be turned into cash within one year, including accounts receivable) and dividing by current liabilities (meaning debt and accounts payable due within one year) – generally banks are looking for liquidity ratios of 1.2x to 1.5x
  3. a longer-term measurement of leverage, where the total debt (including short and long-term) is divided by the total equity value of the business, or alternatively, by the total value of the tangible assets of the business (not intangible assets including intellectual property and goodwill) – it is not possible to generalize what kind of leverage ratios banks require, because different industries are characterized by different ratios depending on their capital-intensiveness and other factors

Each and every business person should have a working understanding of each of these three categories of bank ratios (cash flow, liquidity, leverage), and how they apply to the financials of his or her particular business. Even if the business is pre-revenue and so its actual financial spreadsheets presently have zeros or negative numbers in critical sheet cells, the business needs to have a solid plan to achieve results where after the bank ratios are applied, the business proves bankable.

With regard to the intensifying competition between banks to make C&I loans, business and commercial bankers have clearly heard the message from their management and the regulators that C&I loans are a priority for the banks’ loan portfolios. This is not to say banks are weakening their qualification standards (including meeting ratios) in order to accelerate their C&I lending. The searing experience of the last several years for the banks is still more than close enough that they are not lessening the quality required of “credits” (to use a banking term for loan customers). Instead, banks are increasingly competing on price, meaning the interest rate and points (upfront fees) charged on C&I loans. Talk to a range of business and commercial bankers, and each one of them will tell you that price competition for deals (loans) is intense and intensifying. As a result, now may be one of the best times in a long time for a qualifying business to get favorable C&I financing.

This is true even for businesses which had good financials before the downturn, took a hit, and have come back. Banks know very well that many businesses have had a rough period, but if they have survived to continue in business today, they have been “stress-tested” in the real world. What banks want to see now is a sustained positive trend. What does this mean practically? In speaking with business and commercial bankers across a number of institutions, it means the business needs to have performed positively (including with respect to cash flow, liquidity, and leverage ratios) over the last 4 quarters, in some cases over the last 3 quarters. Mention is sometimes made of a 2 quarter trend, but that has had an aspirational sound to it to my ear.

The above is only a primer. There is much more, of course, to obtaining bank financing than having a working knowledge of ratios, the banks’ thinking on quality versus price, and the banks’ approach to good businesses which have successfully navigated through the Great Recession storm. But these are good starts. The next step is to have at least monthly discussions with two or more business or commercial bankers. If your business already has a lending bank, your contacts with that institution should be broader than one person on the banking team. If your business does not presently have a lending bank, but you envision your business to become bankable in the future, you should start those conversations (plural) now.

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