We live and work in an era of big data. Banks are active participants, keeping a keen eye on metrics that help them accurately estimate risk of default.
As you look for a loan, try to find out how each bank will evaluate your default probability. Many do so using spreadsheets that track multiple financial ratios. When one of these key ideal financial ratios goes askew, a red flag goes up on their end — and the loan may be denied.
To avoid getting “ratio’d” in this manner, business owners should familiarize themselves with some of the more common metrics that banks use to gauge creditworthiness.
For example, banks will compare cash and receivables to current liabilities. If this ratio starts slipping, you’ll likely need to push accounts receivable so money comes in more quickly or better manage inventory to keep cash flow moving. Other examples of financial benchmarks and ideal financial ratios include:
• Gross margin [(revenue – cost of sales) / revenue],
• Current ratio (current assets / current liabilities),
• Total asset turnover ratio (annual revenue / total assets), and
• Interest coverage ratio (earnings before interest and taxes / interest expense).
Some banks may also calculate company- or industry-specific performance metrics. For instance, a warehouse might report daily shipments or inventory turnover, not just total asset turnover. Meanwhile, a retailer might provide sales graphs that highlight product mixes, sales rep performance, daily units sold and variances over the same week’s sales from the previous year.
Bear in mind that not every bank uses ideal financial ratios to evaluate performance, or they may combine ratio analysis with other benchmarking tools. Some use community-based scoring, by which a selected group of finance professionals rate and review companies based on their payment histories. Others use proprietary commercial-scoring models that use creditor reports to develop credit scores for businesses.
When a strategic initiative fails to launch because your business can’t obtain financing, it can be crushing. To prevent such disappointment, have your financials in order and target as many common ratios as possible. Please contact our firm for help evaluating your performance and determining where you may need to improve to obtain a loan.