New entrepreneurs, or business owners who have never dealt with a lending institution before often think that securing a business loan is as easy as demonstrating that you have generated a profit in the past, and your business plan “shows” that you will increase your profits if you get a loan. Unfortunately, it is not that easy. Maybe it should be that easy, but in reality the bank is going to look at a number of other key ratios. Although ratios don’t make sense to the average entrepreneur, the bank will rely heavily on just 3 ratios to get a good picture of your business, so it is important for you to understand how to calculate them and more importantly what they mean and how you can improve. So here are the 3 important ratios that you must understand:
- Leverage Ratio – Your leverage ratio is calculated by dividing your total business liabilities by total business equity. Some suggest that a leverage ratio over 4 to 1 would significantly reduce your chances of securing a traditional bank loan. The basic idea is that your lender doesn’t want you to simply borrow in order to grow the business. You need to put something in as well. So how do you improve your leverage ratio? Pay off your debts and your leverage ratio will come down, or simply increase your cash balance without borrowing.
- Loan to Value Ratio – Your loan to value ratio is calculated by the total dollar amount of the loan divided by the appraised value of the collateral. Most lenders will require the appraised value of your collateral to be higher than the loan amount. The lender is looking at this ratio to see how much breathing room they have. If the business is to default on the loan and the bank ends up with the collateral, the bank wants to make sure they can sell the collateral for a value high enough to recover the entire balance of the loan. You should simply provide the bank with collateral that is appraised for more than the amount of the loan.
- Debt Service Coverage Ratio – This final ratio is a bit more complex, but still incredibly important when applying for a loan. You can calculate your debt service coverage ratio by dividing your annual net income by your annual debt service. Debt service is a fancy way of saying your loan payments. Again this is simply a way for the bank to determine how much breathing room they have. This ratio tells the lender how many times you could make the loan payment with your net income. If you could make the loan payment 10 times with your net income each year, you have plenty of breathing room. If you can only make the loan payments 1.25 times per year, the bank is going to be nervous that if there is any negative downtrend with your business, you won’t be able to make your loan payment. This is simply a ratio that you should be aware of, so that you don’t request a loan that is larger than you can handle.
If you have a good handle and understanding of these three ratios, you will be able to go into the bank with confidence that your loan request is reasonable based on industry standard ratios. Once you create a set of pro forma financial statements based on your proposed loan, go through and calculate these ratios, and you will be far ahead of the average business owner. Good luck!