While there are several factors that go into qualifying for a variety of business loans, there is one metric upon which banks heavily rely, but is unfamiliar to most applicants.
It is the Fixed Charge Coverage ratio (slightly modified for pass-through entity accounting), and it measures your projected ability to pay back the loan with interest better than any other calculation or ratio.
EBIT and EBITDA – Shortcut to Cash Flow
The bank wants to know how many times your cash flow can cover your loan payments. The way they determine cash flow is EBIT, or calculating your earnings before interest and taxes. Your may have heard of EBITDA, which adds Depreciation and Amortization back to EBIT, and I have always contended that this is the lazy man’s formula to derive free cash flow. The investment and banking community have established this standard.
Pass-Through Entity Hides Cash Flow
But the problem with EBIT, or even EBITDA, is that it leaves out a significant decrease in cash flow inherent to S-corps and most LLCs — owner draws or dividends. Due to tax and other reasons, owners of and partners in S-corps, and most LLCs, often receive a large portion of their income as draws or distributions, for which EBIT and EBITDA do not account. A bank, therefore, is possibly seeing a prospective borrower too favorably without accounting for this form of owner compensation.
Modified Fixed Charge Coverage Ratio
So banks have gotten smart. They have taken the Fixed Charge Coverage ratio, which was derived to more accurately determine a company’s wherewithal to make its loan payments than the Interest Coverage ratio, and added the owner draws/distributions to the formula. It is focused on assessing all of the company’s fixed financing commitment, in which fixed distributions to owners should be included. Here is how it works:
[EBIT + Lease Expense + Owner Draws]
[Interest Expense + Lease Expense + Owner draws]
Don’t feel overwhelmed by all of the inputs into the formula; it’s not that hard to pull together.
A ratio of exactly one means the business is running on tight cash flow but it will be able to make all of its obligations. A ratio greater than 1.2 is a comfortable place for a bank to lend, and a ratio over 3 means the company may not be using leverage to its maximum potential.
Here’s an example:
Bob’s Mechanic shop generates EBIT of $80,000 annually. Bob has fixed leases in place of $20,000 and takes another $60,000 out of his company every year as a dividend (he is an S-corp). He pays $15,000 per year in interest. Here is his Fixed Charge Coverage ratio:
[80,000 + 20,000 + 60,000]
[15,000 + 20,000 + 60,000]
Fixed Charge Coverage ratio = 1.68
This means that Bob can cover his existing debt and obligations by 1.68 times. A bank would likely feel comfortable with this ratio if he meets the other loan underwriting criteria and the new loan does not decrease this ratio too much. Interestingly, the interest coverage ratio would have come back over 5, not nearly as realistic as the fixed charge coverage ratio in determining Bob’s ability to service his existing and potential new debt.
Applying for a loan can be intimidating. You should know your ratios, including your fixed charge coverage ratio, before you even start the application. Not only will the EBIT and EBITDA coverage ratio, along with the modified fixed charge coverage ratio help you think like a banker, but it will also help you determine if asking for a loan will help or hurt your business.
About the Author
An award-winning CFO and entrepreneur and best-selling author of Impact Your Business, Ken Kaufman has committed his career to helping start-up, small, emerging, and even medium-sized companies obtain the clarity they need to maximize their potential. He founded CFOwise®, which serves customers internationally, and is an adjunct professor of New Venture Finance at a local University. He can be reached at ken[at]CFOwise.com and on Twitter @CFOwise.