When you’re hustling to start a business or to start growing one, getting financing seems as vital as breathing. Actually lining up a loan, though, is slightly more complicated than inhaling. Lenders weigh lots of different risk factors when evaluating applications.
Here’s an insider’s look at the metrics prized by commercial lenders, courtesy of your friends at ATB.
Total debt service ratio
Your total debt service ratio, or TDSR, is the portion of your gross annual income needed to cover your debts. These debts include any other loans you’ve taken out, as well as mortgages and property management fees. In general, lenders like to see that no more than 42 per cent of your total income is going to servicing debt.
If your ratio is higher than this, don’t worry. There’s a lot that can be done, including debt consolidation. Your banker should be able to help you brainstorm ideas and get started.
High quality collateral
Collateral—what you pledge as security on a loan—is an essential part of any application. Not all kinds of collateral are created equal, however.
The general rule here is that the easier something is to convert into cash, the better it works as collateral. Cash itself is great collateral, actually—provided its origins can be proven. (We take our anti-money laundering measures very seriously.)
Other high-quality forms of collateral include real estate, especially if it’s been appraised, along with equipment or vehicles with proven resale markets.
Depending on your financial situation, a formal personal guarantee can also be a strong piece of collateral. A personal guarantee is a legally binding promise from an individual to repay a corporate debt. Banks like it because it means that if the corporation they approved for a loan can’t pay that loan back, the bank can pursue other parties for repayment.
Your TDSR will come into play here too, and your lender will usually want to see your tax return.
Liquidity plays a big role in any business loan application. We mean the kind related to cash and assets on hand here—not the watery kind. The more cash you’ve got to put towards operating your business, the better your bank likes it, since it proves that you have dedicated resources on-hand to cover the unexpected.
That “on hand” part is important. Liquidity is not the same thing as net worth or total assets under management. The money needs to be available to help make payroll, purchase inventory, make a lease payment, or otherwise keep your business running. Equity in your house and other illiquid assets don’t count here.
So how do you build your liquidity? If your business is already operating, budgeting and a good savings plan can be helpful. Every month, aim to put away a certain percentage of monthly profits to build up the liquidity of your company. The exact percentage will vary with your circumstances, but for most businesses between five and 10 per cent is about right. This capital can be deployed for emergencies or for any key acquisitions. Paying close attention to accounts payable and accounts receivable is also a good idea.
If you’re applying for startup funding, the same basic idea applies—just save income from your current job instead.
Investors can also be useful sources of liquidity for entrepreneurs of all kinds. (Note that securing funding from an investor is very different than getting a loan from a bank. For more information on your financing options for launching a business, read here.)
Working capital ratio
The working capital ratio is a measure of a business’ ability to pay its obligations. It’s calculated by simply dividing current assets (cash, investments, accounts receivable) by current liabilities (accounts payable, income tax payable, accrued wages). A working capital ratio of 1.25 or above is a strong sign to lenders.
Debt to equity ratio
This ratio measures the ability of a business to take on debt financing. Figuring out your debt-to-equity ratio is pretty simple. Just divide total liabilities over total equity. Anything under 3:1 is considered strong. In certain leverage-intensive industries, going up to 4:1 can be OK.
Operating free cash flow
Lenders use this metric to figure out if a business can service a proposed debt. Here’s how it’s calculated:
(Net income + depreciation or amortization + interest - reduction in shareholder loans - dividends) / total annual debt obligations
This ratio should be at least 1.25 for a strong loan application.
Other handy ratios
As you might have guessed by now, loan providers are really into ratios. (Yes, we don’t get invited to parties very often. How did you know?) You could almost say we never met a ratio we didn’t like, except we have numerous spreadsheets demonstrating that our dislike-to-like ratio ratio is roughly 1:1.618.
Here are some other ratios than will help your loan application:
- Inventory turnover ratio—this measures how quickly a business moves through its inventory.
- Accounts receivable and accounts payable turnover ratios—these measure how fast you settle your invoices.
- Gross profit margin—a high-level measure of your profitability.
- Net profit margin—indicates how much of each dollar of revenue a business turns into profit.