Loan Coverage: Ability to Borrow Versus the Ability to Repay
Whether you are a borrower or a lender, the loan coverage ratio is at the heart of all loans. Lenders use a ratio called the debt service coverage ratio (DSCR), to decide if a business can qualify for a loan. The problem, is that there are several definitions, calculations, and thought processes that define the DSCR formulas. Since lenders may have different definitions for the formula, businesses may wish to ask how the formula is calculated; and use the information to select the lender with the most favorable definition that relates to your business.
The most common assets for secured loans are receivables, inventory and net fixed assets. The values of these assets are used to determine if the business has sufficient collateral to meet the lender’s requirements, determining a business’s ability to borrow. The ability to repay the loan is another matter. When reviewing the business’s ability to repay, we need to review several concepts.
The DSCR Rationale
The DSCR measures a business’s ability to repay a loan. Taking an income stream and dividing that by the business’s debt service, the amount necessary to pay principal and interest on loans, calculate this ability for loan repayment. This formula (income/debt service) arrives at a multiple of how many times the business can pay its debt service. A 1.00 (1 to 1 ratio) means the business’s income stream is just enough to pay the debt service. A 1.50 (1 to 1.5 ratio) means the business’s income stream can cover the debt service 1.5 times, while a .75 means the business income stream can only cover 75% of the debt service. In this case the lender will fall short by 25%. The focus becomes how to define the income stream and the debt service. People defined these terms in different ways.
Two of the most common income stream measurements are: one, operating income plus non-cash items like depreciation and amortization (EBITDA); and two, EBIT (no depreciation or amortization). Both methods are earnings variations and both have different assumptions.
The first method adds back non-cash items like depreciation. This implies, either there will be no expected future capital expenditures, or the lender will be providing for capex spending. A business that relies on fixed assets with no capex investment eventually leads to a depleted asset base, resulting in diminished cash flow and ability to repay the debt. The second method, EBIT, assumes depreciation that equals the capex investment. Neither method presents a ‘real’ income stream.
Fiscal Advantage calculates the income stream for the DSCR in two ways. First, we take EBITDA less capital expenditures. This considers the capital needed to maintain business assets. As an alternative, because of its acceptance, the second method we use is EBIT which assumes depreciation is equal to the capex investment.
EBITDA less capital spending, meets most concepts satisfying the best income measurement, to use in the DSCR calculation.
Another factor not usually included, are income taxes. EBITDA is a pre-tax measurement of cash flow, and to not include taxes can overstate the borrower’s ability to earn enough to cover the debt service. EBIDA would perhaps better reflect the borrower’s ability to pay the debt service.
The DSCR measures a business’s ability to earn its debt service, but doesn’t measure the available cash to pay debt service. If the business is not managing its cash very well, and the business has an excess investment in receivables, inventory or other current assets, the business might show an adequate DSCR, but cash might not be available to pay the debt service. This liquidity problem could bring hardship to the business. This speaks to the ability to borrow versus the ability to repay
A formula that better represents a business’s ability to pay debt service is EBITDA, plus working capital changes less capital expenditures and income taxes. This considers the earnings of the business and the capital needed to support sales.
|Available Cash for Debt Service|
|Earnings before Interest & Tax
Plus: Working Capital Changes
Plus: Capital Expenditures
Less: Income Taxes
A lender’s formula for the DSCR can change from one lender to another and from one loan officer to another. It is important to understand the lender’s basis for the DSCR for two reasons. First, it might be beneficial to connect with a lender who is a better fit with your business; and second, once you secure the loan, you want to understand the DSCR in case that is a part of the loan covenants.
Debt service for a new loan is universally accepted as “interest plus this year’s current maturities of long-term debt (CMLTD).” If the loan is a renewal, debt service is “interest plus the prior year’s current maturities of long-term debt.” Let’s assume the following example for a new loan:
|DSCR calculated as (EBITDA after Capex) divided by Debt Service = 3.28.|
|Earnings before Tax||$400,000|
|EBITDA after Capex||$410,000|
Debt Definitions and Basics
Most businesses deal with three types of debt: the revolving credit line, notes payable and long-term debt. The revolver is secured by receivables and inventory and is used to finance current operations. The revolver does not have set terms, but is drawn and repaid as needed. Current notes payable are interest bearing loans, sometimes secured by assets, and are due within 12 months. The term debt is typically collateralized by long-term assets; and has set payment terms, and is generally used for long-term business needs. Long-term debt listed on the balance sheet is the portion that is due in more than one year. Current maturities of long-term debt (CMLTD) is the portion of long- debt due within the year, and is listed as a current liability.
When calculating the DSCR, if the revolving debt or lines of credit are listed as a current liability on the balance sheet, they are expected to be paid off during the year. If the revolver is going to be termed out, that portion that will not be paid in the next year should be under non-current liabilities.
Many businesses have qualified for and secured loans just to find they did not have the cash available to make the payments. Certainly growing companies need continued financing. When forecasting a company’s cash needs, Fiscal Advantage documents the future Cash after Operations as the company’s on-going cash available for capital spending and financing cost (interest). Collateral capacity for revolver loans with acceptable coverage are critical going forward.
Businesses need to forecast their cash needs and their capacity to borrow money, as well as their ability to repay. Understanding the difference between having the ability to borrow and the cash to pay the debt service is critical.
Before going to the bank, determine what your income stream is compared to the expected debt service. It is important to be able to pay off the current debt. Make sure to have the short-term and long-term debt in manageable portions.
Businesses without adequate loan coverage will be restricted and not have access to capital.