The Second of the Five C's Revisited - Capacity

November 20, 2017


Whether you're buying a house, car or a suitcase, there's one factor you're sure to take into account: capacity. When it comes to qualifying for a loan, bankers are no different. Capacity (or cash flow) is the second of the Five C's of Lending (learn about the first C here) and it 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, they ask how much debt could your business could “hold” 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.

Calculating the Debt Service Coverage Ratio

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.

DSCR formula

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). Bankers want to know if the borrower has 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.

Understand Your Projected Future Income

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, projected future income and cash flow may need to be considered. The problem here, of course, is that they are projections that can 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. 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.

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Gary Green

Business Bank of Texas

Gary attended the University of Texas for his undergraduate degree, and then went on to receive a master’s degree from the Southwestern Graduate School of Banking. Since then he’s worked at several banks, most recently as the branch president of First National Bank Edinburg. Prior to that, he served as the senior vice president at Prosperity Bank. Gary has been in banking for over 40 years, and in the Austin market for nearly 30 of those.
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Guide to Business Borrowing

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