5 Important Commercial Loan Ratios to Look Out For

Some business owners mistakenly believe that if their company is generating profits, then they will have no problem securing financing from banks.

It may sound easy to secure a company loan in Singapore, but banks – in reality – look at a number of key financial ratios apart from just profitability.

So, it is important for you to understand, what those ratios are, how they are calculated and what they mean.

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 with income. 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.

Debt Service Coverage ratio is calculated as:-

Debt Service Coverage Ratio = Net Operating Income
                                                       Total Debt Servicing

Example: 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.

Capital Gearing Ratio

This ratio 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 shareholder’s equity. Conversely, 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 shareholder 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.

Debt to Asset Ratio

This ratio measures the percentage of total assets financed by borrowings from creditors and debt. It is usually used as a measure of solvency and the financial stability of a business.

This ratio is expressed in percentage form. One drawback of this ratio is that it is not conclusive 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 = 45%

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

Debt to equity ratio

This ratio 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: 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 low debt to equity ratio signals the ability of shareholder equity to cover all outstanding loans in the event of a economic slowdown.

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 liquid assets which can be easily converted into cash, is available with the company for each dollar of 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: 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.

Business metrics for new startups

Most banks and financial institutions are only willing to extend a business loan to SMEs with operational track record of minimum 2 years.

For startup business loans, financing options are very limited. There are government assisted financing schemes such as the Temporary Bridging Loan Programme and the SME Working Capital Loan  with some form of risk sharing from the government. However, for such schemes, the banks usually make the final decision on credit underwriting.

To position your company with the best chances to qualify for financing or venture capital, you must take note of the below business metrics of your business. Most investors and VCs will probably assess these metrics.

The below key metrics are from Andreessen Horowitz, a reputable Silicon Valley VC firm, and are more applicable to technology startups.

Recurring Revenue vs. Total Revenue

Major source of revenue from most businesses would either be from sale of products, or from labor and providing services.

Most investors usually value the former more. Why? Revenue from labor is non-recurring, has much lower margins; as for the former, you can generate greater profit by sales of product or services that are productized, such as software development.

ARR (annual recurring revenue) is the best metric to evaluate revenue accurately.  It should exclude one-time (non-recurring) fees and professional service fees.

ARR per customer: Is this a flat curve, or an upward curve? If you are upselling or cross-selling other products/services actively, then this curve should be upward, which is a positive indicator for a healthy business.

Gross Profit

While top-line revenue growth is the first figure lenders and investors usually see, business owners should also take the profitability of the revenue into consideration, which can be evaluated by looking at the gross profit.

The calculation of gross profit (GP) varies from one company to another, but generally speaking, all costs associated with the manufacturing, delivery, and support of a product/service are to be factored in as direct costs.

Other indirect costs, financing interest or equipment leasing expenses are not attributed to direct costs for calculation of GP.

Gross profit is simply be revenue minus direct costs.

Total Contract Value (TCV) and Annual Contract Value (ACV)

TCV (total contract value) is the total value of the contract, the term of the contract could be both short and long. Make sure the profit of one-time charges, professional service fees, and recurring charges are included in TCV. On the other hand, ACV (annual contract value) has a set timeframe of a 12-month period.

Is the value of ACV growing? If so, it means customers are paying you more on average for your product over time, which implies that your product is noticeably improving (such as adding features and capabilities), or adding more value.

CLTV (Customer Life Time Value)

Lifetime value is the present value of the future expected profits from the same customer over the duration of the business relationship. LTV determine the total gross profit an average customer brings in and useful in determining your maximum cost of acquiring a customer.

More importantly, you should calculate a customer’s contribution to the net profit of the company, and budget your cost of customer acquisition accordingly.

Contribution Margin LTV/ CAC (Costs of Customer Acquisition) is also a good indicator, it can help you determine CAC payback period, and therefore manage your advertising and marketing spending more scientifically backed by data.

CAC (Customer Acquisition Cost)

Customer acquisition cost refers to the full cost of acquiring users on a per user basis, but it will get more and more complicated as there are different concepts and forms of CAC.

The first mistake people commonly make with CAC is failing to include costs like referral fees and discounts.

Another common problem is treat to CAC as a “blended” cost. It is recommended to calculate CAC with customers acquired through advertising or paid online marketing.

Paid CAC (total acquisition cost/ new customers acquired through paid marketing) is an important indicator. It guides a company whether it should continue to increase its marketing budget to increase profitability.

You must also analyze the CAC from each marketing channel to find out how effective various marketing channels are in customer acquisition.

Month-on-month (MoM) growth

Generally, MOM is very easy to understand, it is simply the average monthly growth rate. But investors often use CMGR (Compounded Monthly Growth Rate) to measure a company’s periodic growth.

CMGR (Compounded Monthly Growth Rate) = (Latest Month’s growth / First Month’s growth)*(1/n of Months) -1). This indicator also helps you benchmark your company against other companies. The CMGR of a growth company is usually lower than the average growth rate.

Net Churn Rate

There are many types of churn in an operation of a company, such as capital churn and customer churn. Every company define these differently. Some companies measure it on an annual revenue basis, which does not exclude the impacts of up-selling.

Investors generally look at the following indicators:

Monthly user churn = lost customers/ total number of customers in prior month

Of course, it is necessary to identify the (capital) gross churn and net churn.

Gross churn: MRR lost in a specific month/MRR at the beginning of the month.

Net churn: (MRR lost- MRR from upsells) in a specific month/MRR at the beginning of the month.

Gross churn reflects the actual loss of business, but understates the level of net churn loss, as it includes the impact of upselling, blending it with absolute churn.

Burn Rate

Burn rate is the rate of decrease on the capital used to support a company’s operation. Once you understand this, you can manage how long a company can continue to be a going concern before it hits certain profitability benchmarks.

Lots of start-ups fail because there’s no subsequent capital support either through equity or loans.

Monthly cash burn = (cash balance at the beginning of the year-cash balance end of the year) / 12. There are also net burn and gross burn.

“Net burn” refers to: Revenues (including all incoming cash you have a high probability of receiving from outside) minus “gross burn”. This is the true measure of amount of cash your company is burning every month.

“Gross burn” often only include the monthly expenses. Investors often look at this indicator, but also look at changes in your monthly expense and income at the same time, because of those changes, your monthly burn rate may not always be the same.