From Nick Reynolds, VP/Credit Services Manager
The risks associated with business lending differ significantly from those associated with traditional consumer lending. While consumer information is still an important part of knowing your member, the types of risks associated with commercial loans tend to be more varied, and wider in scope. This article is one in a series to help credit unions more clearly understand some of the unique risks of business lending.
The “5 C’s of Credit” have long been a cornerstone of prudent business loan underwriting practices. One of the 5 C’s is Capacity, which refers to a borrower’s ability to service its debt obligations from the cash flow of the business. Capacity is most commonly measured by the Debt Service Coverage Ratio (DSCR).
In its simplest terms, DSCR is calculated by dividing the annual cash generated by the business by total annual loan payments. For example, if the business generates $100,000 in cash for the year, and total debt payments are $80,000, the DSCR equals $100,000 divided by $80,000, or 1.25.
However, as is often the case, the devil is in the details. Elements of both the numerator and denominator of the ratio are subject to interpretation.
In the most common methodology, cash generation is calculated by taking the borrower’s net income and adding back depreciation and amortization. Typically, you should subtract any distributions made because they represent cash taken out of the business, and are thus not available to pay the debt. Gains on sales, investment income or losses, and other unusual or one-time items should also be removed. These adjustments help in determining a more accurate picture of the borrower’s ongoing cash flow. Similarly, a loan should not be made based on just a single year of positive performance. As a result of these factors, estimated annual income is often open to interpretation, and all assumptions should be explained clearly.
Calculation of the denominator of the DSCR is generally more straightforward, but does depend upon a full and complete understanding of the borrower’s debt obligations. Underwriting is highly sensitive to changes in DSCR, so it is critical to obtain a debt schedule from the borrower. If a debt schedule is not available, you will need to make some assumptions, and there are some areas where it is easy to misstep. For instance, lines of credit are often misclassified as long term debt. Another example is when a term loan is within a year of its balloon payment maturity. The borrower may have every intention of renewing the loan, yet the entire balance coming due will show up as a current liability.
There are some other refinements to the DSCR that are worth mentioning. You may be familiar with the accounting term EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. If you use EBITDA in the numerator of the DSCR, you should be using the full amount of the loan payments‒both principal and interest, in the denominator. Since the cash generated has the interest added back, it is then appropriate to compare that figure with the full loan payment obligation. Another common approach is to use just net income plus depreciation and amortization in the numerator, and only the principal portion of the loan payments in the denominator. This is a standard approach with larger borrowers that provide GAAP-standard audited financials including a line for Current Portion of Long Term Debt.
Lastly, it is important to consider major changes that will occur in the business as a result of the new loan. For example, in the case of an operating company that is purchasing its first owner-occupied property, you should add back the historic rent payments to the numerator of the DSCR. If the borrower is trading up to a more expensive property, simply add the difference between the prior mortgage payment and the new payment. There may also be additional costs associated with the transaction, such as moving expenses, residual payments under a prior lease agreement, and for renovations or improvements to the new location. It is important to have a conversation with your borrower to determine the nature of such expenses, and to ensure the business has sufficient liquidity to absorb them.
A full understanding and analysis of both recurring and non-recurring income and expense streams are critical to accurate business loan underwriting. At the end of the day, you need a reliable methodology to assess your borrower’s ability to repay their debt obligations. DSCR is a tried-and-true technique that fits the bill.