debt services coverage ratio
The technique which helps analysts to evaluate the creditworthiness of a business is known as credit analysis. When a big corporation issues bonds, the financial statements of the company are analyzed. Prior to making or renewing a business loan to small business, the bank may examine the financial statements of the company. Ratio analysis, trend analysis and other financial analysis like a detailed analysis of cash flows and projections are the basis of doing credit analysis. The management capability, credit history, assessment of collateral and other sources of payments all are included in credit analysis.
Before approving a commercial loan, the cash flows of the borrower will be examined by bank along with other financial factors. The debt service coverage ratio is the classical measurement of repayment ability during credit analysis. The cash generated by a company will be calculated by a credit forecaster at a bank. Cash flow amount divides by the debt service to get the debt service coverage ratio. The standard set by most banks are minimum of 1.2 the debt service coverage ratio should be maintained by a business in order to afford its debt requirement.
There are five basic components of credit analysis:
Capacity to repay
The most critical factor amongst five factors is the capacity to repay; it is the primary source of repayment of cash. The lender’s prime concern is the ability of borrower to repay the loan during credit analysis. The probability of successful repayment of the loan, the timing of the repayment and the cash flow from the business are the points of concern for the lender. Other possible sources of repayment are also the interest of the lender. The future payment performance also depends on payment history on existing credit relationships.
Collateral or guarantees
You can also provide additional forms of security to lenders, such as collateral or guarantees. You pledge an asset you own, such as your home, to the lender as collateral on contract that if you can’t repay the loan, the collateral will be the repayment source. On other hand, guarantee is a different phenomenon. In guarantee, someone else signs a guarantee document promising to repay the loan if you can’t.
Capital
Capital is the indicator to lender that how much of the risk of borrower is involved in the business. Capital is the money that you invest in the business. Capital has a great significance during the process of credit analysis.
Conditions
The purpose of the loan is described by conditions; either loan is used for additional equipment or for working capital. The investor also considers the external analysis of the related business as well as other industries which may influence the business. This analysis includes the macroeconomic conditions as well as microeconomics conditions, such as: Social, political, economical, technological, legal and environmental.
Character and background
The general impression of you on the lender is known as character. Lender will consider your educational background and business experience to evaluate you during credit analysis. The characteristics of your business and employees will also be considered by the lender in the process of credit analysis.
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