Are you a business borrower looking to assess your borrowing capacity and serviceability? In this article, we will explore key measures that are essential for understanding your financial standing and ability to meet debt obligations. Discover the Interest Cover Ratio (ICR) to gauge your ability to pay interest on outstanding debt and the Debt Service Ratio (DSR) to assess your capacity to repay all debt obligations.
Assessing the borrowing capacity of a business borrower involves evaluating capacity and serviceability.
Here are key measures to consider:
1. Interest Cover Ratio (ICR)
This ratio measures a business’s ability to pay interest on its outstanding debt. Depreciation and amortization are typically not added back in this calculation. For example:
Total EBITO ($946,000) /Total Interest ($85,000) = 11.13
When a company’s interest coverage ratio falls below 2.0, its ability to meet interest commitments may be questionable, especially if future income reliability is uncertain.
2. Debt Service Ratio (DSR)
DSR assesses a business’s ability to repay all debt obligations. For example:
Total EBITDA ($946,000) /Total Repayment Obligations ($760,000) = 1.24
If this ratio is 1.0 or lower, cash flow will be negative. The closeness to 1.0 depends on the quality and certainty of the business’s income.
Tip: DSR is a relevant measure of liquidity as it considers the actual cash commitment to reducing debt. The gap between DSR and ICR can be significant when strong amortization is required.
3. Multiple Earnings
Applying multiple limits to the adjusted EBITDA can help determine borrowing
capacity. This method is increasingly popular for service firms. For example:
Total EBITDA ($946,000) x Maximum Multiple of 3.0 = $2,838,000 (Indicative Borrowing Capacity)
Tip: This method is suitable when consistent EBITDA is evident and when lending lacks tangible security.
Covenants and Ratios
Covenants are restrictions or requirements that lenders impose on borrowers. These covenants help monitor the borrower’s performance and can be quantitative or qualitative, positive or negative. It is crucial for business owners to have financial literacy in this area to prevent covenant breaches.
Typical covenants include
Calculate Sales divided by Accounts Receivable. This ratio measures the rate at which Accounts Receivable are being collected annually.
- Debt/EBITDA Ratios
- Interest Coverage Ratios
Example – “The aggregated actual EBITDA of Key Choice Pty Ltd is required to be: A. 1 July to 31 December each year, $450,000; and B. 1 July to 30 June each year, $900,000.”
Qualitative performance measurements may include:
- Limitations on new purchases
- Assets are serviced
- Control of Dividends
For example, in Bank Speak: “Key Choice Pty Ltd is to ensure distributions do not exceed 100% of the NPAT.” Compliance with covenants and regular monitoring is a sign of a well-run business.
In conclusion, serviceability is critical to assessing a business borrower’s borrowing capacity. The key measures discussed, such as the Interest Cover Ratio (ICR) and Debt Service Ratio (DSR), offer valuable insights into a business’s ability to meet interest and debt obligations.
Additionally, the Multiple of Earnings method provides a popular approach for determining borrowing capacity, especially for service firms. Covenants and ratios play a vital role in monitoring borrower performance and are essential for preventing covenant breaches.
By understanding and applying these measures and strategies, business owners can demonstrate their financial literacy, secure financing, and ensure the success of their well-run businesses.
To discuss your business’s serviceability and opportunities for your business,
The information provided in this blog is for educational purposes only and should not be considered financial advice. Always consult with a professional financial advisor or lender for specific lending decisions.