Lending is an important revenue and profit driver for a financial institution. Loans also are a critical funding source for small and large businesses. Loans can be unsecured, which means the lender has no recourse to the borrower's assets, or secured by collateral assets that serve as a backup source of payment. Lenders use the collateral coverage ratio and other factors to decide whether to grant a loan application request.
The collateral coverage ratio is equal to the total discounted collateral value divided by the total loan request. Collateral refers to personal and business assets, such as a house, car, office equipment, truck and heavy equipment, inventory, receivables, stocks, bonds and certificates of deposit.
The U.S. Small Business Administration and lending institutions use different discount factors for different types of collateral assets. The SBA uses approximately 80 percent of a home's market value, while a bank might use 75 percent. The SBA might value receivables that are under 90 days overdue at 50 percent, while a bank might assign a 75 percent valuation. Lenders usually value certificates of deposit at 100 percent, because they are liquid and secure short-term investments.
For example, if a business pledges an office building with a market value of $1 million and $250,000 worth of receivables as collateral, the discounted collateral value is $1 million multiplied by 75 percent, or $750,000, plus $250,000 multiplied by 50 percent, or $125,000, for a total of $875,000. If the business requests a loan of $500,000, the collateral coverage ratio is equal to $875,000 divided by $500,000, or 1.75.
Small business borrowers normally make their loan payments from operating cash flow. However, when they run into financial difficulty and are unable to make the payments, lenders have a fiduciary responsibility to their shareholders to get their money back. For secured loans, a lender can force the liquidation of a delinquent borrower's collateral assets to recover the loan amounts. Therefore, a high collateral coverage ratio gives the lender added assurance of recovering his loan principal in case of delinquency or default.
Small business consultant John W. Nelson III wrote in an article for "The Savant" that lenders typically look for a collateral coverage ratio of 1.0 or better. Borrowers with lower ratios might need an SBA or some other form of guarantee to secure a loan. The collateral mix also plays a part. For example, if a borrower pledges high-quality real estate as collateral, a low coverage ratio might be enough to secure a loan.
Other Lending Factors
Financial institutions use several factors to assess loan applications. For example, the debt-to-equity ratio should not be more than four, according to the SBA. This ratio is equal to a company's total debts divided by its equity, which consists of retained earnings and partner investments. The loan applicant's credit history and ability to repay the loan also play a role in the evaluation process.