When it comes to commercial loans, banks consider a borrower’s financial position and reasonability. To evaluate the lending risk for the borrower and their willingness to pay back the debt, banks look at your financial position through a few different ratios. This article covers the most relevant four metrics that any bank uses to make a decision regarding a loan application and helps paint a picture of what may be asked from you.
What are the Commercial Lending Ratios?
Commercial lending ratios help banks to determine how much money they intend lend to a borrower together, and along with the interest that will accrue from the money given. These calculations are done considering the ever-present risk because, just like everything in life, they are not given out for free. The following formulas are included:
Debt to Equity Ratio
- Cash Flow to Debt Ratio (Coverage Ratio)
- Loan to Value Ratio
- Debt Service Coverage Ratio
Whether one is granted a loan greatly depends on knowing these ratios. To have a better shot at getting a loan, it is essential to have an understanding of your financial situation along with these ratios to ensure they are within acceptable limits.
Debt to Equity Ratio: A Measure of Risk
This ratio is very significant when considering different types of ratios. This ratio measures how much debt the company can take compared to its equity invested. The ratio value decreases, the better it is for the company’s ability to obtain additional loans.
How It’s Calculated:
Formula: Debt to Equity Ratio = Loan Amount ÷ Investment
Example: If your investment is ¢2.5 lakh and your loan is ¢3 lakh, your ratio would be 1.2. This means for every ¢1 of investment, you have ¢1.20 in debt.
When the loan request is made with a lower ratio, it becomes easier, taking into consideration the equity that is able to cover the loan. Higher ratios eventually spell greater financial threat to the bank.
Cash Flow to Debt Ratio: Ensuring Loan Repayment Ability
Cash Flow to Debt Ratio provides an indication regarding the company’s capacity to service the loan obligations based on its operating cash flow. This ratio is important as it provides the banks the position of your liquidity for the payback of the owed amounts.
How It’s Measured
Formula: Debt: Cash Flow Ratio = Cash Flow ÷ Loan Amount
Let’s say your cash flow is 6.25 lakh, and your loan amount is 25 lakh. Your ratio would be 25%. In this scenario it illustrates that every year you can service each loan portion. The loan would be completely cleared within a total of four years.
Loading more debt does not hinder cash flow even when debt is serviced, this means it is possible to repay load in less time. Companies with lower ratios would have a tougher time servicing their loans
Loan to Value Ratio: Risk Associated With the Collateral
The lender evaluates every credit facility by analyzing the total loan amount towards the pledged asset. Over time, the value of collateral usually relies on decline secondary real estate.
How It’s Measured
Formula: LTV Ratio = Loan Amount ÷ Asset Value
Example: Let’s take the case of purchasing a one crores house. You decide to go for an 80 Lakh loan so your loan to value ratio is now 80% and your bank expect you to put in 20 Lakhs.
An above 80% loan-to-value ratio is not recommended, as it poses a risk for the bank, which is why it is in the bank’s interest to keep it lower.
Evaluating The Repayment Capacity: Debt Service Coverage Ratios
The Debt Service Coverage Ratio (DSCR) indicates the level to which your income is sufficient in repaying the existing obligations. For example, a higher DSCR means that you are in a more favorable position to pay off your debt.
For Example: If your income is Rs. 100,000 and your monthly EMI stands at Rs. 50,000, then your DSCR is 2, meaning, in that employment, you can comfortably afford paying double the EMI.
From his side, the bank knows that the borrower having high DSCR is assumed to have or will earn enough to make the payments without trouble, so they are considered to be at low risk.
Key Points About Loan Approval
Debt / Equity ratio, anything less than 2:1 is favorable due to an over concentration of debt.
Debt / Cash Flow Ratio: The higher ratio signifies that you should be able to repay the loan quickly, this makes the bank more at ease while granting loans. Ideally. this ratio should be 25 percent or even higher.
Loan/Value ratio: The GPA decides with the bank if it will LTV which should empirically be on the low side, ideally below 80%.
Debt Service Coverage Ratio: For the purpose of this example, an ideal DSCR is between 1.5 to 2. This means, at the very least, your income is sufficient to pay off the loan, and there’s enough left over for livingexpenses.
Conclusion:
Get All The Documents Required Before Applying For A Loan
Understanding the commercial lending ratios is extremely important for your loan application. These metrics put you in a much stronger position to bargain with the financial institution and as a result, they would be more willing to finance your project. Minor actions like boosting your cash flow can be benefit your debt to equity ratio, loan to value ratio, debt service coverage greatly, and as a result, the lender tends to your application faster and the terms of lending are softer.
Hence, these financial ratios are very important for any individual or business because it ensures that they get their loans approved while at the same time protecting their finances in the future.
