The Numbers That Matter

Here's a secret: Bankers don't actually read financial statements -- at least, not at first. Here's what they do look at.
Magazine Contributor
5 min read

This story appears in the November 2010 issue of . Subscribe »

If you've applied for a loan, it may surprise you to learn that a banker can look at your company's financial statement and know, in a matter of minutes, whether it's likely to fly. Though the final decision will obviously involve more analysis -- largely to ratify and document the initial assessment -- that first hairy eyeball test is aimed at answering three questions: Can you pay? Will you pay? And, what if you don't pay?

The numbers that determine the answers are probably not the ones you think. The truth is, bankers don't actually read financial statements -- at least not initially. Instead, the bank's credit department crunches your statement though a program that produces ratios based on key income statement and balance sheet numbers. And these ratios are what matters first.

So if you want to secure a loan, it's important to understand the ratios, what they say about you and how you can make them work in your favor.

Can You Pay?
The primary ratio a lender uses to determine whether you can afford a loan is the "cash coverage ratio." It's calculated by taking your net income and adding back depreciation and amortization, which aren't cash expenses. That gives a rough indication of your net cash flow -- what's left over after the bills are paid. Then that number is divided by the annual payments on the proposed loan to arrive at the cash coverage ratio.

According to Brett Mansfield, senior vice president of business banking for Union Bank, bankers will want to see a ratio of about 1.5 or higher. So, if the payments on the new loan total $20,000 a year, a net cash flow of $30,000 would make the grade.

A secondary source of cash flow, such as your spouse's income or other personal income, can be taken into consideration if the cash coverage ratio shows the business can't support the debt on its own. Be sure to let the bank know if such a source exists.

Will You Pay?
How you've handled debt in the past is considered a good indicator of how you'll handle it in the future. Your personal and business credit score (likely from Dun & Bradstreet) will play a big role in answering this question, but your "debt to worth ratio" will weigh heavily on the answer, too. It tells a lender how much of you is at risk. If you're heavily financed with other people's money (not including investors'), you'll be considered a high risk.

The debt to worth (also known as the debt to equity) ratio is easy to calculate. Just look at your balance sheet and divide shareholders' equity by total liabilities.

Union Bank and other lenders will want to see that your liabilities (debts) are no more than three or four times your equity. So if you have $50,000 of equity, you should have no more than $150,000 to $200,000 of debt.

By the way, be sure to let your lender know if there's any "friendly debt" on your balance sheet (perhaps a loan from a family member). If Uncle Joe is willing to subordinate his loan to the bank's (in other words, allow you to pay the bank off before you pay him), your lender can treat it as equity instead of debt. That could dramatically improve your debt to worth ratio.

What If You Don't Pay?
If the worst happens, a lender wants to know there are tangible assets that can be liquidated to pay off the loan. Hard assets of equal or greater value collateralize the majority of small-business loans upward of $50,000 or by a general filing of all business assets.

Let's say you bought a piece of equipment with $75,000 of hard-earned cash last month, and today the lender assigns a collateral value of just $45,000. What's with that? The difference is because if the bank has to sell it, it'll rarely collect its full value. The following rules of thumb will give you an estimate of the value a bank assigns to various types of collateral:

  • Accounts receivable: 20 percent to 85 percent
  • Inventory: 10 percent to 80 percent
  • Furniture and equipment: 10 percent to 80 percent
  • Real estate (business or personal): 50 percent to 90 percent
  • Cash/investments: 50 percent to 90 percent

Whether your collateral is valued at the high or low end depends on its quality and marketability. In the case of accounts receivable, the quality of your customers, their credit ratings and their payment history will determine the collateral value. With inventory, it depends on what it is, where it is, how old it is and whether anyone wants it. One of the banks I worked for had a sporting goods store close up shop without any hint of financial trouble. When the bank seized the collateral, what it found was largely past its sell-by date -- think white bathing caps covered in plastic flowers.

Anything you can do to prove the salability of your assets will help your collateral case. Just be sure your lender knows what you know. Mansfield adds that ratio expectations aren't hard and fast. A suboptimal debt to worth ratio might be offset by strong cash flow, for example.

The final loan decision will take into account many factors, financial and otherwise, but to a lender, ratios are like the jacket copy on a book. If they don't read well, your lender may not bother to look any further.


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