Two Credit Ratios

Lenders have a number of ratios and formulas they use to evaluate credit applications, to set ongoing debt covenants, and to review renewals.

I find two of them are most critical. They are intertwined, and if you can meet them, the rest of the covenants and ratios tend to take care of themselves.

First ratio: Debt to Earnings. More specifically this formula would be total debt divided by earnings before interest taxes, depreciation and amortization (EBITDA).

There are refinements to it. For example, if the company routinely carries high cash balances, they can be used to offset the debt in the formula. But, that’s not usually an adjustment made for small and mid size companies, because cash balances are usually pretty thin.

Most mid market companies are either subchapter S or LLC companies under the tax code. So, the company does not pay taxes. But, the bankers will want some acknowledgment of the distributions necessary to the owners to pay their personal share of the taxes.

And, the earnings number in the denominator needs to be reduced for capital expenses (CAPX). An easy assumption is that depreciation will equal CAPX, so no adjustment for either in the formula. But, if CAPX is much different than historical depreciation, it needs to be recognized.

There are a few other tweaks that can be made to the ratio: annual minimum property tax payments, rents, lease commitments, and some others, but the big ones are the debt, the projected earnings and depreciation.

What’s the target? One senior commercial lender recently told me his bank’s range for this ratio was 3.0 to 3.5. Meaning: the ratio of debt to earnings should be no higher than 3.0 to one, but must not be higher than 3.5 to one.

Second ratio: Fixed Charge Coverage. This is EBITDA (same number as in the first ratio, so you can see how interrelated they are) divided by next year’s fixed charges. The fixed charges are interest, principal reductions on installment loans, and maturities.

Again, some adjustments to the fixed charges may be needed, like CAPX, minimum repairs above routine maintenance, taxes, leases, and so forth. Each client is a bit different, depending on their business model.

Maturities in the next year can really cause this ratio to fall, especially lines of credit, so some adjustment is typically made to recognize that the routine lines of credit for receivables and inventory are rolled over.

What’s the target? Same banker said 1.0 to 1.5. So, the bank would like to see the ratio above 1.5, but it must be above 1.0. As you can imagine, losses ruin both of these formulas.

An example: Total debt $1,000,000. EBITDA of $350,000. Fixed charges (interest and principal maturities) of $180,000. The debt ratio is thus 2.85 ($1 million divided by $350,000) and the fixed charge coverage is 1.94 ($350,000 divided by $180,000). Targets met. But, if you move the base numbers just a bit, you can see how quickly the ratios change and blow the targets.

From time to time, depending on credit conditions, banks move these targets around. But, the interplay continues because interest and principal payments in the fixed charge ratio are driven by the debt balances, and both the debt ratio and the coverage ratio include earnings in the base. To improve these ratios, earnings need to be higher, debt levels lower (typically meaning higher equity in the business) and interest rates lower.

They are two good ratios for any business to monitor.