On paper, it's about as un-sexy a subject as you can imagine. Nevertheless, your business's debt coverage ratios are a critical component of any underwriting process.
Even if your credit history is flawless, lenders will still want to determine whether the income you're earning is sufficient to pay both your current debt load and what you're proposing to borrow from them.
Think of them as doctors assessing your business's financial health--signs that you're becoming too leveraged are viewed as clogged arteries that may indicate a premature demise.
This is where companies often get declined--even companies that would seem to have all their ducks in a row otherwise. I wouldn't be surprised if it's the source of the joke that banks lend you money only when you don't need it. Unfortunately, there's a grain of truth in every joke, so it's important that you don't come across as desperate. Play it cool instead.
Debt coverage ratio may be looked at in a variety of ways depending on which bank is looking at your request, as well as the type of loan you're applying for. It can also be calculated by summing all your monthly debt payments (both existing and new) and dividing that amount into your monthly net income (personal and business).
There can also be two separate calculations--one for business debts and one for your personal debts. Some banks will only look at the business net income and debts (existing and proposed), and disregard the personal debt as long as it's not excessive.
Generally speaking, banks want to see a business debt coverage ratio of 1.5 and a personal debt coverage ratio of 3 to 4. In order to understand how these ratios are calculated, here are a couple examples:
If you have $2,000 in monthly debts now (personal and business) and have a monthly income (personal and business) of $10,000 per month, your debt coverage ratio is 5 ($10,000 divided by $2,000). Anything above four is considered acceptable. If you're seeking a loan for $50,000, where the monthly payment will be $500, your monthly debt service payments would increase to $2,500 per month, which when divided into the gross income of $10,000 results in a debt coverage ratio of four, which is still acceptable.
If you have $2,500 in personal debts and another $500 in business debt, and if your new loan will have a $500 payment--bringing your total business debt up to $1000--you'll need to show personal income of $7500 to $10,000 a month (3 to 4 in the debt coverage ratio) and $1500 in business net income a month (1.5 debt coverage ratio).
Keep in mind that banks will usually ask for the amount of interest your business paid in a year. They add that back to your net income before calculating your debt coverage ratio.
For example, if you showed $48,000 in net income for the business, and your interest costs were $12,000 for the year, they'll use $60,000 (or $5,000 a month) to figure out your debt coverage ratio. The reason they add this interest back in is because they want to recalculate what your debt coverage ratio will be with both the existing debt and the new debt.
Exciting as watching paint dry, right? Get used to it. When it comes to your ability to repay their money, lenders want as little excitement as possible. I've taken out a lot of loans over the course of my career; believe me when I say that better your grasp of the state of your finances, the better your chances of enjoying the same success.