Top Stories | Fri, 20 Dec 2024 03:14 PM

How Lenders Assess Debt Financing: The Key Financial Ratios

Posted by : SHALINI SHARMA

Now when companies are looking at sourcing through debt financing, there needs to be a lot done in terms of going out through financial health, ensuring this will return the loan. Of course, credit and the planning, but quantification it is through financial ratios the lending institution uses to classify on how it actually places a risk for having some about your company. Let us, therefore, choose some of the leading financial that lenders use and relevance regarding why it matters for determining risk.

1.Debt-to-Equity Ratio (D/E)

The debt-to-equity ratio establishes the percentage of financing by debt and the equity present in the capital of the company. This simply portrays the extent to which a firm makes use of leverage. When referring to a higher use of debts, the ratio is high; this increases the risk for lenders while reducing the usage of the firm as a debt financier rather than equities.

Explanation: When D/E ratio is 2:1, that is two dollars of debt and one dollar of equity per dollar. That is a very highly leveraged situation that would signal financial instability.

Why It Is Important to Lenders: Lenders prefer firms with balanced D/E ratios, which means the company is not dependent on borrowed funds. A high D/E ratio is a disadvantage to the business in raising more capital and has more risk in repayment.

2.Debt Service Coverage Ratio (DSCR)

What It Means: DSCR is a measure of whether a company's operating income is adequate to service its debt, with both principal and interest. In other words, a DSCR of 1 or better means that the firm will be able to service its debt, while a DSCR of less than 1 may indicate that it can't.

Interpretation: If the DSCR of a firm is 1.5, then it means that the company has made 1.5 times more income than the income necessary to meet its debt obligation, so this provides just a little bit of buffer for an unexplained decline in revenue.

Why It Matters to Lenders: Typically, lenders want a DSCR of 1.2 or more. A very low DSCR means there is little wiggle room between unexpected expenses or a change in income and being able to service the loan.

3.Interest Coverage Ratio

Interest Coverage Ratio Formula:

What It Means: This ratio provides the information on how well a company can service its interest expense with its operating income. In simple words, it is an indicator that reflects how good the company will be at servicing its debt expense before tax and other costs.

Explanation :If the interest coverage ratio of a company is 3, then it means that the business pays three times the interest that it annually incurs. That will be a good signal of its ability to service the debt.

Why It Matters to Lenders: Lenders love to see a high interest coverage ratio. That means that the borrower is comfortable with its debt obligations. A ratio less than 2 is considered risky.

4.Current Ratio

What It Tells About: Current ratio is a measure of liquidity. In other words, this indicates how well the company would pay off the short-run liabilities using the short run assets. That's what is called the short run health meter for a firm.

Explanation: Meaning, if the current ratio is 1.5 it means there is $1.50 in assets available to service a dollar in liability. So the firm shows pretty well on liquid.

Why It Matters to Lenders: A ratio of less than 1 indicates that the company may not have sufficient cash to pay off its short-term obligations, placing it in a vulnerable position for financial instability. Generally, lenders prefer a ratio of greater than 1.

1.What is the D/E ratio, and why should the lender care? 

The D/E ratio measures total debt divided by equity held by shareholders. This will let the lender know about the level of financial leverage that exists and whether the borrower has the ability to service more debt. High D/E ratio means a lot of risk is involved, and low D/E ratio means much favor toward lenders. 

2.What is DSCR, and how does a lender use it? 

DSCR is a debt coverage ratio that determines the potential ability of a company to use its operating income to repay the debt service. The value is determined as follows: Net Operating Income/ Total Debt Service. It will be able to repay debt if the DSCR exceeds 1.0. This is one requirement in the process of debt approval. 

3.How could the Current Ratio be used as a way to measure the liquidity of a firm when it is financing with debt? 

Current Ratio = Current Assets / Current Liabilities

This is a measure of short-term liquidity as well as a measure of how well a company can pay for current liabilities. Any number greater than 1.5 is great in the eyes of the lender. 

4.What impact would an Interest Coverage Ratio have on the decision to finance with debt? 

The Interest Coverage Ratio measures how well the company is able to service the interest on the outstanding loans as EBIT / Interest Expense. A better ratio, above 2.5, is highly desirable to lenders; else, the company hasn't been servicing its loans satisfactorily. 

5.Why should a lender care about the Quick Ratio more than the Current Ratio? 

The Quick Ratio is also called the Acid Test Ratio. It does not ignore the inventory and reveals how well an enterprise can liquidate only liquid assets to finance short-term liabilities. That is more conservative than the current ratio and more informative of creditors about immediately liquid resources. 

6.How is the LTV Ratio used by lenders in making loanable decisions?

LTV Ratio=Loan Amount/Appreciation of Asset Value It is very crucial for secured loans, such as real estate. If LTV is minimum than 80% percent risk of loan of lender would be lesser than more; hence probability will go higher.