When a business approaches a financial institution for a loan, more is required than a business plan and financial information. A commercial lender must analyze several areas before it will agree to lend a business money. A few of these areas are referred to as ratios, and a business must achieve certain scores for a lender to consider a business' request for financing. If a business wants to avoid a surprise, it should calculate these ratios itself before approaching a lender. Then if something needs improved upon, the business can do so before involving a financial institution.
The debt ratio is the debt capital divided by the business' total assets. Current and non-current assets and debt are used to calculate the ratio. The ratio is used to determine how much a company relies on its debt to finance its assets. The lower the debt to asset ratio, the more likely a business is to be granted a loan. For example, a company that has $100,000 in assets, but only $50,000 in debt is a better risk than a business that has $100,000 in assets and $75,000 in debt.
Debt Service Coverage Ratio
The debt service coverage ratio, or DSCR, measures a business' ability to generate adequate revenue to cover the mortgage payments. The ratio is calculated by dividing the net operating income by the total debt. For example, if a business has a total operating income of $100,000 and total debt of $60,000 the debt service ratio would be 1.67. This means the business operates with 66 percent more revenue than it needs to cover its expenses. Any ratio more than 1 is considered a good risk for a bank.
The loan-to-value, or LTV, Ratio is the borrower's total loan balances divided by the fair market value of the desired property. The fair market value is based on the property appraisal. The ratio is composed of a numerator and a denominator. The numerator is the loan balance total. If the business has no other loans, then the numerator is the requested loan amount for the current property. The denominator is the property appraisal. For example, if a business wants to borrow $150,000 to buy property that is appraised at $200,000, the LTV would be 75 percent ($150,000/$200,000). Lenders look for a LTV ratio of 80 percent or less. A ratio higher than 80 percent can mean a higher interest rate or special requirements the borrower would have to agree to in exchange for the lender to take a higher risk. Of the three lending ratios, the LTV ratio carries the most weight with the underwriter when determining whether to grant the loan.
- InvestorWords.com Debt ratio
- InvestorWords.com: Debt service coverage ratio
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K.A. Francis is a freelance writer with over 20 years experience, and a small business consultant and jewelry designer. She holds a Bachelor of Arts in English and business administration and a Master of Arts in Adult Education. She has written for "The Einkwell," "Windsor Parent," MomsOnline, Writer's Stew, Lighthouse Venture Group and others. Her jewelry design company, KAF Creations, has been in operation since 1998.