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Get these things right and you are the darling of the banks

In this blog post, I want to share what banks are really interested in when they look at the financials of a company. Knowing these particulars and you will be well prepared when you next apply for some business finance facility. Spoiler alert: The bankers don't expect that you be a higher-achiever in all the areas discussed in this post but they at least expect that you know what drives them.

Debt servicing ratio

Throughout my career when it came to dealing with the banks, whether it was applying for a new credit line, negotiating covenants, or switching banks I always prepped ahead of the meetings to stress the things that matter most to them.

One of the ratios that always came under scrutiny was the Debt Servicing Ratio, calculated as follows: EBITDA – Dividends dived by debt servicing costs.

EBITDA stands for earnings before interest tax, depreciation, and amortization. Calculating this figure is quite simple. You just take the Net profit of the period and back the tax charge for the year, interest, depreciation, and amortization.

EBITDA is used by many is an approximation of a company's cash-generating power from its core operations. Ideally, companies are able to grow this figure on a yearly basis or at least keep the EBITDA when putting it in relation to its sales. A decreasing trend in absolute terms and relative to sales signals deteriorating business fundamentals, which is a red flag for banks.

Debt Servicing costs are not only the interest you pay on all your credit lines but also the capital and principal repayments. I had a few discussions with bank representatives and I tend to agree that purely taking the interest to assess how comfortably a company can meet it is financing obligations is quite redundant. In a low-interest environment it normally easy for companies to pay the interest but things certainly become trickier once you include the loan repayments! Therefore I fully agree that the Debt servicing ratio is the better metric to concentrate on.

The exact target rate assigned by the bank depends on a few factors as outlined below. But crucially everything has to be viewed through the lens of risk. The riskier the overall business and its environment them ore stringent the target rate to achieve will be

  1. The size of the company: Smaller companies normally have to take on larger amounts of debt if they want to grow operations, therefore are considered riskier and subject to tougher rules.

  2. Maturity of the company: Companies that are the beginning of their lifecycle may want to take on more debt to grow unless they have such high earnings power that they can grow out its own cashflow. More mature companies may have already built more cash reserves therefore they don't require external funding anymore.

  3. The industry the company is in: Banks tend to have different outlooks for different industries. In general the more upfront risk there is the more stringent the rate will be. Especially high capital intensive industries such as the automotive and the oil industry have more stringent rates applied but once operations are in a more mature stage rates are normally relaxed

  4. The nature of the business: Here I refer to the cyclicality of the business. Some businesses are subject to swings. Think about the leisure industry. They normally have more business in the winter and summer but autumn and spring are rather flat seasons. Cyclicality also refers to companies that are particularly subject to the boom and bust cycles. Automotive companies are a good example of this. As long as the economy roles people are buying cars but during a recession or an economic downturn things normally a bit bleaker. Banks don't like moody company performance. They like consistent performance. Think of Microsoft as an example: Everyone buys its products no matter the economic weather. So the more a company is subject to the swings described here to more stringent the rate will be.

What you have to bear in mind is that banks try to encourage prudent lending on the company's behalf. They are a bit like parents telling their children when it's enough. They just want us to behave well.

But as a rule of thumb, any company should avoid falling below 1.5. If it should fall below 1 it essentially means that you don't even have the money to satisfy the obligations due within a year. If this is the case I hope you have got your crash helmet on. Every Finance manager should track this metric if the company has any debt on its balance sheet.


Gross leverage

The calculation of this metric is as follows: Total interest-bearing debt divided by EBITDA. By total interest-bearing debt, everything needs to be included for which the company has to some sort of interest (a bond pays a coupon which is a form of interest).

The same criteria as outlined above apply to setting the target rate for Gross Leverage. With regard to the interpretation of this ratio, banks want to determine how long it takes a company to repay its entire debt out of earings. As a rule of thumb, the target has to be half of the average term of all the company's credit lines and financing facilities. Let's assume that the company finances all its capital expansion with credit lines with a 5 years term. Assuming the EBITDA is 2 million GBP per year and the credit lines amount to 10 million GBP. You get a rate of 5 (10 million of Total Debt / 2 million of EBITDA). This would mean that you would be able to just about service your debt within the 5-year term. Therefore strive to make it in half the time which in this case is 2.5 years. This is another ratio every finance manager needs to track on a consistent basis.


To summarize:

The fundamentals are important hence always be prepared to explain the direction of your EBITDA what causes it rise and fall and where you anticipate it to land in the years ahead. You also need to know your debt structure, when it matures (the length of the term or time to repay), and how much you have to service on an annual basis (which includes loan repayments and interest costs).

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