Lessons from the Field: Typical types of lending ratios – What makes the bank anxious?
Banks are crucial for small businesses and mid-market companies in Canada, as they are one of the main sources of funding to drive innovation, development, and growth. However, a study conducted by BDC found that financing is still one of the key barriers for SMEs to grow, and SMEs still present a likelihood of stagnating or shrinking over the course of a three-year window due to lack of funds.
The way it works is that banks make assessments regarding a company’s past beforehand through a credit check – if it has a bankruptcy history or an unpaid debt, that will influence negatively towards the lending decision. Banks also have to consider certain factors before making their funding decision, such as businesses’ interest coverage ratios, the size of the ask, the business’s tangible net worth and the working capital support they require, along with the available security in accounts receivable and inventory.
To make a bank’s threshold for lending, a company has to have a good interest coverage ratio. It is considered important by investors since it determines if a company will be able to grow and survive despite having to make additional loan payments. If a company is almost not meeting its financial obligations with their current earnings, they might make themselves financially insolvent.
The interest coverage ratio is calculated by dividing the earnings before interest and taxes (EBIT) by the amount a company has to pay on its outstanding debts to creditors (principal and interest). A minimum acceptable interest coverage ratio is 2 for a company that has consistent revenues. Ratios of 3 or more are better. Ratios of 1 or less indicate that a company is not doing well financially and hence, banks will tend to avoid them.
Regarding term loans, it is important that companies have a plan beforehand for what they are going to do with the money, as it is crucial for a bank’s decision. Otherwise, the business might not be able to be eligible for funding. Tangible net worth is also another very important factor that might make banks hesitate to lend – it illustrates the value in liquidation of a company in the case of bankruptcy or sale. Subordinated debt can complicate its calculation and might cause banks not to lend, as it is a liability that has lower priority than other debt but that allows subordinated debt holders the right to claim against property.
Finally, for working capital loans, which are investments that help finance a business’s daily needs, banks subtract a company’s current liabilities from its current assets. This calculation assesses a company’s short-term liquidity, which is its ability to pay the bills, as they become due. Depending on how well a company can pay their bills, banks will determine their likelihood of lending or not.
They also get anxious when depositors pull their money and loans start to deteriorate. In situations like these, banks have to raise additional capital quickly and they end up bringing other borrowers into their capital structure. If there is a bad loan, banks will most likely reduce their credit available and not lend to a certain company or industry.
Overall, companies have to be able to prove to bank lenders that they can meet all financial obligations and show them a good balance between debt and equity financing. Small businesses and mid-market companies make an important economic contribution to Canada, as they generate 16% of all jobs and accounts for 12% of our GDP and 17% of our exports. However, it is important that SMEs keep their balances in check and are able to pay for their loans, in order to keep the Canadian economy moving.
What’s happened to Canada’s mid-sized firms? https://www.bdc.ca/en/Documents/other/BDC_study_mid_sized_firms.pdf
Canadian banking and lending 2013, A mid-year pulse check. https://www2.deloitte.com/ca/en/pages/tax/articles/canadian-banking-and-lending-2013.html
The 6 criteria used to assess requests for financing. https://www.desjardins.com/ca/business/projects/finance-business/prepare-request-financing/6-criteria-used/index.jsp
The trouble with banks. https://www.economist.com/special-report/2003/05/01/the-trouble-with-banks
Working Capital Loan. https://www.thinkingcapital.ca/knowledge-center/working-capital/
What is Line of Credit secured by Accounts Receivable? https://www.comcapfactoring.com/blog/line-of-credit-secured-by-accounts-receivable/
What is a good interest coverage ratio? https://www.investopedia.com/ask/answers/121814/what-good-interest-coverage-ratio.asp
How to meet SBA’s loan criteria. https://en-ca.ondeck.com/resources/how-to-meet-the-sbas-loan-criteria/
Tangible Net Worth. https://www.investopedia.com/terms/t/tangiblenetworth.asp
How to Calculate Your Tangible Net Worth With Subordinated Debt. https://www.fool.com/knowledge-center/how-to-calculate-your-tangible-net-worth-with-subo.aspx