The Second of the Five C’s Revisited – Capacity

One of the considerations you may take into account when you’re buying a house, car, or just a suitcase is how much will it reasonably hold. Looking at the capacity of these things is not so different from what bankers look at when deciding whether to make a loan or not. Capacity (or cash flow) is something a lender will review and analyze to determine if a business or individual has the ability to repay the loan in a reasonable and timely manner. In other words, how much debt could this business be “holding” and still generate sufficient profit and cash flow to operate comfortably.

In order to answer this question, there are a number of credit analysis metrics that may be used by lenders to consider in their decision making process. The primary ratio is the “Debt Service Coverage Ratio” or DSCR.

This ratio is generally defined as EBITDA (Earnings Before Income Taxes, Depreciation and Amortization) less income taxes and capital expenditures divided by the estimated principal and interest payments over the next 12 months.

An obvious starting point is the borrower’s historical ability to service existing and proposed debt (usually derived from the previous 3 years of financial information). Has the borrower generated sufficient free cash flow to comfortably repay the projected loan payments? The amount of the payments required over the next year, or “debt service”, includes the payments on the new amount of debt under consideration. In some cases the available historical cash flow information may be sufficient to cover the additional debt service requirement.

In those cases where it is not, then projected future income and cash flow may need to be considered. The problem here, of course, is that they are projections and they could always change. You should be prepared to defend your projections and explain why they are reasonable. To provide realistic projections, they must be based on past trends that are sustainable. Providing the rationale and assumptions that led to your projections are even more important if the historical figures are not enough to ensure a borrower will be able to service an increasing debt load. A lender will want to see an acceptable margin in a borrower’s historical or projected cash flow. In other words, a DSCR of 1.2X or greater is usually necessary.

It seems obvious, but the primary goal in lending is that the loan will be repaid. It is always a good idea to take a closer look on your own at your actual numbers from prior years operations, current interim numbers, projections, and then arrive at a number or ratio that will be of interest to your banker and be an indicator of your ability (capacity) to repay the loan.

Next month we will talk about collateral and the famous last words that usually spring up – “Don’t worry, I have lots of collateral.”