Which Two Financial Ratios Appear Most Frequently in a Loan Agreement?
When your business borrows money from a bank or other lender, the loan comes with rules that must be followed while the loan is still outstanding. These are called loan covenants. If you breach the covenants, the loan can be called, which means that you must pay it back immediately. One common covenant is that your business must maintain a certain level of solvency. This is measured by applying ratio analysis to the company's financial statements.
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Loan Covenants
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Banks often require more of their business clients when they issue a loan than simply having to make monthly payments. The bank's main concern is that they will be able to recover both the funds loaned and the interest. To prove to the bank that the company is solvent enough to continue to make those payments in the future, the bank will apply solvency ratios to the company's monthly or annual financial statements. The company must maintain a minimum or maximum ratio to stay within the rules of the loan. The two most common ratios used by banks are the debt-to-equity ratio and the working capital ratio.
Debt-to-Equity Ratio
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The debt-to-equity ratio is calculated as the total amount of debt a company has divided by the total amount of equity it has. The purpose of the ratio is to show how much of the owners' own money is invested in the company versus how much of other people's money they are using. Banks often require a maximum debt-to-equity ratio. If the company starts taking on more debt, the ratio will rise. The bank will consider a company with high debt ratios more at risk to default on the bank's loan as well as all of the other debt.
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Working Capital Ratio
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The working capital ratio is calculated as the total current assets divided by the total current liabilities. The ratio shows the bank whether the company will have enough money in the next 12 months to pay all of the debt it owes in the next 12 months. The bank will set a minimum working capital ratio that will show an excess of current assets over current liabilities. If the ratio starts to slip, especially if it goes below 1:1, the company may experience a cash flow crunch in the coming year, lessening the chance for the bank to recoup the loan.
Improving Ratios
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As a business owner, you should know your covenanted ratios on an ongoing basis, long before you have to report them to the bank. If your ratios are getting worse, the sooner you step in to correct them, the more chance you will have at staying within the loan's rules. Paying down debt helps both ratios but it is critical to ensure that you have enough cash flow to make the extra payments. If you instead take the extra available cash and invest it in equipment or other capital assets, it may be good for the business but it will hurt your working capital ratio. Calculate how much cash you will have to retain to keep the ratio within limits and then invest the rest.
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