4 Need-To-Know Aspects of Banking and Lending
When it comes to banking and lending, things can get confusing fast if you don’t have a good understanding of how essential aspects work. As a result, you could be losing money without realizing how significantly that lack of knowledge is draining your finances. The good news is, lending doesn’t have to be confusing.
Here’s what you need to know:
Put simply, interest coverage (also: interest cover ratio, times interest earned, TIE) is the ratio of debt to profitability. It’s used to identify how easily your business can pay the interest on debt.
To figure out your own interest coverage ratio, take your earnings before interest and taxes (EBIT) within a specified period. Divide it by its interest expense.
When a lender evaluates whether your company can take on more or new debt, they’ll calculate this ratio and heavily rely on it to determine if lending to you is a good option.
Because of this, you’ll want to check in on your interest coverage before applying for a loan. A good interest coverage ratio represents a business that understands how much debt it can manage and a good risk for the lender.
Debt Service Coverage
Debt service coverage (DSCR) is the ratio that measures how well your cash flow covers debt obligation. You’ll use this formula to find out the debt service coverage lenders and investors will use to evaluate your ability to pay.
First, figure out your EBIT, also called net operating income (NOI). This is before taxes and will appear on your cash flow statement. Exclude principal and interest payments on loans, capital expenditures, depreciation, and amortization to get this number.
Next, get the debt servicing. This is how much you need to cover the principal and interest.
Divide EBIT by Debt Servicing. Anything less than 1:00 is considered a negative cash flow, so the higher the number, the more income you have to pay this debt in the eyes of the lender.
Let’s say you have a decent ratio, and the lender approves the loan, as part of your loan agreement, they may require you to maintain a certain DSCR throughout the life of the loan. It’s therefore critically important that you thoroughly read the loan agreement to know:
- What you’re signing
- How to your bank calculates the DSCR for your loan
- What happens if you become non-compliant
You’ll need to work quickly to increase your profitability if you begin to slip below the DSCR.
Working capital (NWC) is current assets minus current liabilities. This number represents liquidity and operational efficiency to a lender. Strong working capital means you have the potential to invest in your company and grow. Low working capital represents the opposite and even potential bankruptcy.
Note: working capital can be represented as a ratio by dividing rather than subtracting these two numbers.
High NWC may be good news for lenders. But if it’s too high, this may suggest you’re sitting on too much inventory or not effectively investing your cash, so keep a close eye on this category and monitor its movement to a targeted working capital position that suits your needs.
Line of Credit
A line of credit (LOC) is a short-term borrowing instrument provided by banking institutions to provide an advance on your working capital assets (inventory and receivables). Setting up a line of credit allows you to tap into it at any time for a certain number of years. You only borrow as much as you need at any time, as long as the total doesn’t exceed the borrowing base limit, as defined in your line of credit loan agreement. You can keep paying it off and borrowing more up to your limit as needed.
An LOC offers a business a lot of flexibility because you don’t have to qualify for it when you need it. Your bank is trusting you to manage that flexibility well.
How might you use a LOC? Let’s say you come up short on payroll one month because of lower-than-expected revenues due to a supply chain issue. Cash is tight. You can make sure your people are paid on time by tapping your LOC. Avoid an HR and PR headache and keep things moving despite the ups and downs.
Need Advice for Banking and Lending?
Banking and lending can be confusing. It helps to have a partner who both understands what you’re signing, and how the above work with your current financial situation. Turn to an experienced accountant. Let’s set up a meeting to discuss.