Important Ratios in Commercial Underwriting
There are several important financial metrics that banks or lenders use in order to know if a potential borrower qualifies for a commercial loan. The purpose of using these metrics is to measure the risk associated with the borrower and an indicator to the lender of how much the investment is worth. Each bank or institution varies in regards to specific requirements and some banks may be more lenient than others. Regardless of which metrics a bank or institution may use, they all essentially need to know the same thing; does the borrower qualify for a loan?
One of the most commonly used measures include the debt ratio and is derived by taking the total amount of debt a company has and dividing it by its’ total assets. Debt ratio measures may vary in definition depending on the industry observed but for the most part, a high ratio indicates that the company does not have sufficient leverage. In other words, the company holds a lot of debt in relation to its assets. While a low ratio is preferred, a ratio that is too low in comparison to the rest of the market may indicate that the company is not utilizing its resources adequately in order to increase its profitability. The debt ratio gives the lender an insight on the health of the company and makes it easier to decide how risky making out the loan is.
Aside from the debt ratio, another vital metric used, that is perhaps the most important metric of all, is the debt-to-cash flow ratio or most commonly known as the leverage ratio. This measure is taken by dividing the company’s debt by its cash flows and measures how many years of cash flow it will take the company to withdraw from the debt. The reason it is such an important metric in underwriting is that it’s a prospective measure and is not affected by amortization or current interest rates. Unfortunately, not many commercial lenders actually use this important risk measure, but instead use the debt service coverage ratio (DSCR). Similar to the leverage ratio, the DSCR measures how many years of cash flow it will take to pay the debt off but is not a prospective measure and instead is a current one. In contrast to the leverage ratio, the higher the DSCR the more attractive it is to the lender.
As mentioned before, these measures are very important in credit analysis because they allow the lender to identify the risk measures involved. In order for a company to know beforehand if it will qualify for a loan, it is important to contact a loan representative. The loan representative can steer the borrower in the right direction after gathering the right information in order to put together an appropriate recommendation for the company that is borrowing.