Three Key Ratios
Tony Gray and Matthew Gillman walk through the three ratios a lender has in mind the moment you describe your business: debt service coverage, debt to EBITDA, and accounts receivable to accounts payable. Know them before you apply and you know your odds.
What is the debt service coverage ratio?
Tony Gray: It measures how much cash flow the business generates against its debt payments: cash flow available for debt service divided by annual debt payments. It is the same question a mortgage lender asks: is there enough income to pay the loan?
Matthew Gillman: If you make a dollar and owe a dollar of principal and interest, you can afford your debt. The question is whether there is a cushion: can you lose a contract and still make the payments? The higher the ratio, the better for you and the more comfortable the lender. To know it you need accrual-based financials. Cash-basis books only show money in and out, not whether you are truly making money.
How do companies end up unable to afford their debt?
Matthew Gillman: Payments creep in a few thousand dollars at a time, and with cash flowing in it is easy not to notice. A cash flow lender, such as on an SBA 7(a) loan, looks at every payment you have. But application-only equipment financing, a $40,000 machine, then $80,000, then $150,000, is underwritten one piece at a time without the global picture.
We see companies making half a million a year with a million a year in equipment payments. Only the interest hits your P&L; the principal comes off the balance sheet. But if you do not generate enough cash, there is nothing to pay it with.
What DSCR do lenders look for?
Tony Gray: It varies. Large banks are more conservative, smaller local banks less so. The minimum is 1.0, exactly enough cash to make the payments, which is risky. A common rule of thumb for an ideal ratio is 1.25: 25% more cash coming in than goes out on debt, a cushion if a customer does not pay.
Matthew Gillman: Banks fall on the conservative side. In private credit it depends on the product. More collateral or personal guarantees can offset a tighter ratio. SBA loans carry a government guarantee to encourage lending, so they often accept a lower ratio. Interest-only products and asset-based lines have no amortization, so they focus more on collateral coverage. Whatever it is called, every lender asks whether the business can afford the payments.
Should I ask a lender for its ratio requirements up front?
Matthew Gillman: Yes, but start a step earlier: stress test yourself. A 1.0 ratio leaves no room for anything to go wrong. Some owners are not comfortable even at 1.25, because one contract is 50% of revenue and its option year comes up in three months. Taking on long-term debt against a short-term renewal is how you end up unable to pay. Work out what you can truly afford before you approach a lender, because a good lender will do exactly that.
Tony Gray: Some lenders, wanting your business, will not volunteer their minimums, and you can spend four to six weeks on paperwork only to be told no. Treat it like a bid: do not bid where you do not meet the requirements. Ask where you stand, and keep more than one lender in the conversation: a large bank, a community bank and private credit.
What is the debt to EBITDA ratio?
Matthew Gillman: It shows how much money is available to repay debt and over what period. EBITDA of $5 million against $15 million of debt is a ratio of three: about three years to repay. It matters if a lender ever decides to term out a line of credit, converting it into payments over a few years because its appetite has changed. If the ratio works, the company can afford that.
Tony Gray: Banks typically look for 2.5 to 3.5 times. Private credit may tolerate a higher ratio, perhaps four to six.
Is EBITDA the right number to look at?
Matthew Gillman: I tend to work off net income more than EBITDA. Depreciation is a paper transaction, so add it back. But you still pay taxes, and while you have debt you pay interest. And principal repayment does not hit the P&L: you could repay $5 million of debt out of $5 million of earnings and still owe tax on it. The bigger the company, the more nuance there is in all those letters.
Tony Gray: Ask your lender which ratio matters most to them, and what their ideal and minimum are.
What is the AR to AP ratio?
Matthew Gillman: Are you owed more by your customers than you owe your vendors? If you are owed $5 million and owe $2.5 million, that is $2.5 million sitting between them: a very healthy ratio. Watch for a company paid on net 30 that takes net 60 from its vendors, using them as a free line of credit.
A one-to-one ratio is only fine if the company makes money. A company losing money sees its payables grow faster than its receivables; a profitable one sees receivables grow faster.
Tony Gray: As a rule of thumb, banks look for about two times receivables to payables. Private credit may accept one to one.
Do I need perfect numbers to get approved?
Matthew Gillman: No. If a lender cares about five core things and one is weak, you have a good chance. Three strong and two weak, your chances drop. Two strong and three weak, you have a fundamental problem to fix before you look for financing. Ask whether you can afford it, whether it benefits you, and whether the whole scenario makes sense, and bring the lender a package that is easy to decide on.
Tony Gray: Knowing your ratios is bankable behavior. Walk a lender through your AR, AP and DSCR in the first conversation and ask where you stand. It saves everyone time.
Read more on this
- What lenders actually underwrite, in the complete guide
- Government contractor loans, compared
- Contract line of credit
This is an edited version of the conversation: spoken repetition is removed and each answer leads with its point. Every figure and example is as said in the episode. For financing specific to your business, talk to us.
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