Article by Roger Schlueter, MBA
Banks have always looked at the Debt Coverage Ratio for a Commercial Loan. They look at this ratio sometimes in different ways but it all boils down to this question: Does the Borrower Have the Cash to Pay the Debt Service on Your Loan and is there a Cushion of Cash to Cushion Your Risk? Many of the banks customers have Commercial Loans that may be linked to their personal assets or cash flow. They are linked in different ways so it becomes a challenge to figure out if your borrower has the cash to pay his loans and what will happen if his cash is reduced or if the interest goes up on his loans? The fact that some of his loans may be at different banks only confuses the issue.
The answer to this dilemma is the Global Debt Coverage Ratio. The Global Debt Coverage Ratio looks at the borrowers Business Debt Coverage Ratio and also his or her Personal Debt Ratio. Some banks just user the same Debt Coverage Ratio to look at the Business and then extend that ratio to include the income and debt of the individual. They basically take all the income and divide it by all the debt service in business and personal use. This ratio can mislead many a banker and a bank.
The actual way to look at the Global Debt Coverage Ratio is using two different ratios. The Debt Coverage Ratio for the Commercial Debt and the Debt to Income Ratio for the Personal Debt.
The Business Credit Debt Coverage Ratio is a very simple ratio to calculate. The basic ratio is the Available cash flow, divided by the Total Debt Service. Available cash flow means, Cash Flow, that is left to pay the Total Debt Service. Cash Flow is Net Income plus Depreciation (and other non-cash charges). The Ratio is used in Commercial Lending but mainly in Real Estate Commercial Lending.
Simple Company Example:
Sales $100,000
– COGS $500
Net Sales $500
–SGA $300
= Net Income $200
Net Income $200
+ Depreciation $25
+ Interest* $50 (interest is added back in, because it is part of the Debt Service)
Cash Flow $270
Debt Service – Annual $200
Debt Service Coverage Ratio is $270 / 200 = 1.35
Of Course you want this ratio to be over one (this will cover the Debt Service) but most banks would like to see it at 1.25 to 1.30 as a minimum. They feel that gives enough of a cushion to weather any increases in interest rates or decreases in income.
Simple Rental Property Example:
Rental Income $100,000
– Vacancy (10%) $10,000
– Rental Expenses $15,000
Prop Tax & Maint.
Rental Income $ 75,000
Debt Service $56,250
Debt Service Coverage Ratio is 1.33
The Big Deal with Rental or Commercial Property is the Vacancy Number. The Vacancy rate can be higher if there is only one tenant and lower if there are more that one tenant.
Now we could extend this ratio to the Personal Debt and Income but this ratio does not represent the analysis of the Persons Personal Debt and Income as well as the Debt to Income Does. You need both.
The Rule of thumb for Debt to Income for personal lending is a ratio. This ratio is obtained by taking the Total Debt (this amount may or may not include the new debt but it usually does include the new debt.) and dividing it by the Total Income of the individual or married couple. The Debt is the Payment per month or Year that an individual has and divide that by the Total Income of the Individual per month or year.
Example:
Joe has a mortgage payment of $1,000. He has a car loan with a payment of $300 as well as several credit cards with a combined payment of $500. Joe’s Total Monthly Debt Payments are $1,800. Joe’s Income per Month is approximately $5,000. His Debt to Income would be 36%. The bank would like the Debt to Income to be 40% or less including the Mortgage and 30% or less without a home mortgage.
Joe has a little room, approximately 4% of his income or $200 of which he can increase his Debt per month and be within the banks ratio of Debt to Income of 40%.
Now if Joe did not own his home and did not have a home mortgage then the ratio would be $800 divided by $5,000 or 16% and have approximately 14% of room to be within the banks 30% guidelines.
Most banks look at these as just that, a guideline. There can always be room for movement one way or the other. This is just a general guideline and banks may be higher or lower in the percentage of Debt to Income.
Summary: You need to look at both the Debt Coverage Ratio and The Debt to Income Ratio when looking at business debt and personal debt on a Global Basis. They actually measure different things in different ways. It has also been proven that if you use only the Debt Coverage Ratio, it can lead to information that is not accurate.
Please call me or email me at roger@rogerschlueter.com or on my Website at schlueterfinancial.com