5 Important Commercial Loan Ratios to Look Out For

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5 Important Commercial Loan Ratios to Look Out For

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Several entrepreneurs or business owners believe that if their company is generating profits, then banks or other lending institutions will not hesitate to extend funding to them.

It may sound easy to secure a business loan in Singapore, but banks – in reality – look at a number of key ratios apart from just profits. So, it is important for you to understand, what those ratios are, how they are calculated and what they mean.

1. Debt Service Coverage Ratio (DSCR)

Also known as DSCR, this ratio is the measure of cash available to repay the company’s outstanding debt obligations. It is an important ratio, and is often used by the bank’ risk credit assessment approvers for underwriting business loans, as well as commercial real estate loans.

It must be noted that many lenders routinely assess the DSCR of the borrower before they offer any form of financing.

As a rule of thumb DSCR ratio of 1 is ideal, and if it is less than 1, then the borrower might not have enough resources to service loan payments.

Creditors could have a hard time recovering their loan or interest payment if financing is extended to a borrower with low DSCR ratio. Debt Service Coverage ratio is calculated as:-

Debt Service Coverage Ratio = Net Operating Income

                                                          Total Debt Services

Example à Net Operating Income = $140,000 per year; Debt Service = $100,000 per year

DSCR = 140,000/100,000 = 1.4

In this case, the Net Operating income of the company is enough to cover existing debt 1.4 times.

2. Capital Gearing Ratio

This ratio is related to the capital structure of the business, and measures the proportion of debt financing and equity financing. Gearing ratio is used to assess the long-term financial stability of the company. This ratio might also affect the valuation of a company. 

A company would be considered lowly geared if a higher proportion of total capital is common stockholder’s equity. Similarly, a highly geared company would be one with higher proportion of the capital in the form of debt or fixed interest/dividend bearing funds.

 Capital Gearing Ratio = Common Stockholder Equity

                                               Fixed Cost bearing funds

Example: Common Stockholder Equity = $3,500,000; Preferred Stock = 9% : $1,800,000; Bond Payable = 6%:  $1,400,000

To Calculate the Capital Gearing Ratio, Fixed cost bearing capital is to be calculated first, which is Preferred Stock+ Bond Payable : $1,800,000+$1,400,000 = $ 3,200,000

Capital Gearing Ratio : 3,500,000 / 3,200,000 = 1.09

From the above example it is clear that the company is lowly geared.

3. Debt to Asset Ratio

This ratio measures the percentage of total assets financed by borrowings from creditors, through debt and liability. It is usually used as a measure of solvency, and to identify the financial stability of the company.

This ratio is expressed in percentage form. One drawback of this ratio is that it would not tell everything about the asset quality of the company.

Debt to Asset Ratio = Total Debt/Total Assets

Total Debt: Long term liability+ Current Liabilities (Long-term and short-term debt)

Total Assets: Current Asset +Fixed Asset +Tangible and Intangible asset

Example:

Current assets                                      500,000

Non-current assets                              845,000

Non-current liabilities                         340,000

Current liabilities                                 270,000

Total assets = $500,000 + $845,000 = $1,345,000

Total debt = $340,000 + $270,000 = $610,000

Debt to Asset Ratio =                          $610,000/$1,345,000 = 0.45

A low debt to ratio suggests that the company’s assets are not generated from operational cash flow and does not rely on excessive debt to fund assets acquisition.

4. Debt to equity ratio

This ratio again informs about the financial and liquidity position of a company. To put it simply, it is the percentage of financing that comes from the investors and creditors. A higher debt to equity ratio means the company is more leveraged, and more financing has come from creditors.

Debt to equity ratio = Total Liabilities

                                         Total Equity                     

Example à A Company has a SME loan of $100,000 and mortgage of $500,000 over commercial property. Shareholder Equity is $1.2 million. Debt ratio would be:

          $100,000 + $500,000 =       0.5

                   $1,200,000

A debt to equity ratio of 1 would mean that both investors and creditors have 50:50 stakes in the business assets. One can say that lower debt to equity ratio is positive for the company and that the company is financially sound.

5. Quick Ratio

As the name suggests, this ratio defines how quickly the company can meet its current liabilities. This ratio helps in calculating how much quick asset which can be easily converted into cash, is available with the company for each dollar of the liability.

This ratio is also called acid test ratio. A company with high quick ratio is seen as a net positive from lender’s point of view, suggesting there is no dearth of assets to take care of the short-term liabilities.

Quick ratio = Cash+ Cash Equivalents+ Short-term Investment+ Current Receivables

                                                                             Current Liabilities                                                                    

Or

Total Current Asset –Inventory – Prepaid Expenses

                              Current Liabilities

Example à Cash: $10,000; Accounts Receivable: $5,000; Inventory: $5,000; Stock Investments: $1,000; Prepaid taxes: $500; Current Liabilities: $15,000

                                                     $10,000 + $5,000 + $1,000   = 1.07

                                                                        $15,000

Ratio of 1.07 means the company has enough assets to pay near-term liabilities.

Apart from the ones discussed above, there are few other key ratios as well that most lenders will take into consideration for commercial lending – Loan to Value Ratio, Debt Yield Ratio and Loan-to-Cost Ratio.

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