A construction company once approached me for advice. They’ve been in business for five years at that point, and they have never borrowed money before that time. They did approach banks, but they weren’t sure how to tell them about what they need. The president was an engineer by profession. His wife was the one in charge of their financials.
They managed to succeed through hard work, and now they have their sight on bigger contracts. To be specific, they were looking to get supply and install contracts from one of the Top 100 corporations in the Philippines. Realizing that they need more money than they have now, they approached banks to ask for advice. Unfortunately, the answers they got didn’t manage to clear up their questions.
You see, this business needed some analysis done on their financial statements. They know they needed more money, and they had a rough idea how much they wanted to get from the bank. However, they wanted to know how much they can SAFELY borrow. That amount escaped them.
INTRODUCING THE DEBT SERVICE CAPACITY RATIO
So what I did was dig deep through their business and their financial statements to see how I could help. Among other things, the most important concept they learned was the Debt Service Capacity Ratio. This is one of the most important computations you would have to make for your own business when planning to raise money.
As the name implies, it’s a measure that compares your income towards the regular payments you have to make towards your loans. It computes how many times your income can cover those regular payments. For example, a DSCR of 2:1 means that you have twice as much as income for a particular period compared to the loan payments you have for the same period of time. A ratio of 1.5:1 means that you have 1.5x, and so on and so forth.
Banks have different ways of computing this ratio, but in general, you want to have a ratio that is at least 1.5:1. Anything lower than could be dangerous for your business, depending on several factors.
COMPUTING THIS RATIO
You may want to compute the ratio differently – depending on the nature of your business. If your sales are mainly cash sales, then the first formula would suffice. Though if you have a lot of sales on credit, then you may want to use the second computation.
1. EBITDA Computation
So here’s the formula:
EBITDA/Total Annual Debt Amortization
EBITDA means (earnings before interest, taxes, depreciation and amortization). In most financial statements, you can compute this by deducting Gross Profit less Operating Expenses, excluding depreciation expenses, interest expenses and amortized costs. These expenses are excluded because they are non-cash expenses.
Total annual debt amortization refers to the sum of all debt payments (both principal and interest). You should be able to compute this through some simple calculations, or through using an amortization calculator <link>.
2. Cash Computation
The EBITDA formula can be misleading for a business who does more sales through credit than through cash. EBITDA doesn’t really distinguish if you have received cash for your sales or not, but your debts are always paid in cash. Using that formula in situations like this may lead to the wrong conclusion that you can pay a loan that you cannot.
As an alternative, you might want to use this formula:
Cash After Operations/Total Annual Debt Service
Cash After Operations is all cash sales and collections less all cash operating expenses. You can see this figure in your Cash Flow Statement if your accountant did it correctly.
The total annual debt amortization is the same as the previous formula.
With these two formulas at your disposal, you can now make an educated decision on how much you can safely borrow from the bank.