Important Ratios for Bankers
When applying for a bank loan, banks determine your creditworthiness and risk. Banks want to ensure that you are capable of paying back the loan and the interest on it. They need to assess your business solvency for the short-term and determine your leverage for the long-term. Two important measures bankers use are Fixed Charge Coverage Ratio and Debt to Net Assets. Banks will have an acceptable range for each of these measures, and the range will vary across industries.
Fixed Charge Coverage Ratio
To determine if you can pay all your fixed charges banks use Fixed Charge Coverage Ratio (FCCR). Fixed charges typically refer to certain fixed expenses of your Company such as Debt Service (principle and interest payments), rent expense, and sometimes distributions of profits. FCCR is a solvency ratio, so it measures how easily your firm can cover its costs coming due. A typical formula for FCCR is:
(Earnings Before Taxes,Interest,Depreciation and Amortization (EBITDA)+ Rent Expense)/(Rent Expense + Interest+Principle Payments on Debt+Unfinanced CapEx)
Why do banks care? For you to pay the bank back, your company needs to earn enough to ensure you can cover your fixed charges, failing to do so will result in defaulting on the loan and possible bankruptcy. FCCR measures how many times your earnings can cover your fixed costs before interest, so a higher ratio is better. A ratio of 3 means that your earnings before taxes can cover your fixed costs three times. If your FCCR is below 1, it is a red flag as your income does not cover your costs; this is not sustainable in the long run. Although the acceptable range of FCCR depends on the industry, a value of 1.25 to 1 are is generally acceptable.
Debt to Net Assets
Aside from knowing if you can pay your fixed costs, banks also want to know how much of your assets are financed through debt. Debt is a necessary part of business, and often a reasonable amount of debt is preferred as it provides many benefits. However, too much debt can lead to financial trouble and potential bankruptcy when business slows down.
Debt to Net Assets measures how leveraged you are; a lower ratio is preferred:
(Total Liabilities)/(Total Assets-Total Liabilities)
As with FCCR, banks will have an acceptable range for Debt to Net Assets that varies by industry. A higher ratio will make it more difficult to obtain a loan and will often come with a higher rate and stricter terms. For example, a 3 to 1 ratio is very high but in some industries that number is not too high because the revenue stream is more predictable.
Determining the right amount of debt in your capital structure is important and should be based on industry acceptable levels. Overleveraging can make further financing difficult.
Banks look at many factors before providing a loan; FCCR and Debt to Net Assets are two of the most important factors. Before applying for a loan ensure you know your ratios and the industry range.