Managing Cash flow during the ongoing uncertainty with the Covid-19 pandemic has been the biggest challenge facing Small and Medium Businesses. With most SMB’s looking for Small Business Loans to keep afloat, the BDC has been saturated with financing requests. Alternative lenders such as Kingsmen Capital have bridged some of this gap, providing flexible loans to small businesses within 4-5 days of application.
However, in order to be eligible for financing, SMB’s must keep in mind pertinent financial ratios that lenders base investment decisions on. According to the BDC, the 3 most prominent financial ratios are: Debt to Equity, Debt Serviceability and Debt to Asset ratios.
Debt Serviceability is the most important factor lenders look at while providing short term financing and small business loans. This ratio is measured by dividing the company’s EBITDA by interest and principal payments and essentially shows how much cash a company generates for each dollar it owes. In essence, this provides lenders with an estimate of how much free cash the company generates in order to service debt obligations.
The debt to equity ratio compares the company’s debt to shareholder’s equity. A high debt to equity ratio indicates that the company is significantly leveraged, and therefore poses a riskier investment for lenders. In the event that revenues decline, the company will find it difficult to pay back their business loans as their liabilities exceed net assets. A high debt to equity ratio also makes it difficult for companies to obtain more debt in the future. However, the optimal debt to equity ratio varies from company to company and industry to industry. Some firms may take on a higher debt to peruse an aggressive expansion which may also reflect in higher earnings for the company.
Lastly, the debt to asset ratio shows how much of a company’s assets have been financed by debt rather than shareholder’s equity. If this number is relatively high, the company again poses a riskier investment for lenders and chances of defaulting increase, especially in the face of rising interest rates. If the ratio is higher than one, the company’s total liabilities exceed assets. On the other hand, if the ratio is less than one, it shows that a large chunk of the company’s assets are financed by shareholder’s equity, and not by debt.
Viewing these ratios and navigating your company’s financial position keeping these indicators in mind will not only help you get financing at lower costs, but also with relative ease. The BDC and Kingsmen Capital both use these ratios to analyze which companies will be able to pay back the small business loans deployed to them and therefore which companies are a safer investment.
Sood, Alka. “3 ratios to monitor the long term financial health of your business after COVID-19”