As we try to approve our new loan process here at CenterState, one area that we are focusing on is a better pre-qualification process. Faster prequalification of credit is a recent trend at banks as we all desire to be more efficient and deliver an answer to our client sooner. To do this, many banks have created a “pre-flight” or preliminary credit memo that is driven by financial ratios. In this manner, not only can an early credit opinion be formed, but a priority of credit can be assigned. To do this efficiently, most banks have found success in creating a one-page memo with a short narrative of the transaction, an outline of the loan terms and then the numerical credit analysis of the borrower. In this post, we explore what financial ratios to include, why and what rank or weighting you should give them.
The Basics: Financial Statements and The Foundation for Ratios
While financial statements provide the results of a borrowing entity, proper ratios analysis allows the lender to explain the reasons for the results. Ratios combine two or more financial numbers to create a context to help analyze the creditworthiness of a borrowing entity.
For underwriting purposes, of the three financial statements, the cash flow statement is the most important, followed by the balance sheet, and lastly the income statement. Any lender that can properly understand the details of the cash flow statement is way ahead of the game. Simply understanding that the income statement is the least important of the three financial statements is a good start (too many poor underwriting decisions are the result of overemphasizing or misunderstanding the income statement).
The three statements can be summarized very simply as follows: the income statement demonstrates profit achieved by calculating revenue minus expenses for a given period (typically annual or quarterly. The balance sheet explains the net worth (assets minus liabilities) at a moment in time. Finally, the cash flow statement shows all of the sources and uses of funds. Unfortunately, the financial statements typically serve to confuse most users by containing too much information for underwriting purposes or by hiding the information that is most relevant for lending decisions.
Ratios combine financial results from any of the three financial statements and can succinctly demonstrate the reasons for an entity’s financial performance. The ratios allow the user to consider three very important aspects of credit analysis: 1) trends of the entity over time; 2) comparison of the entity within an industry (how well the company is doing compared to its peers); and, 3) how well the industry is doing relative to other bankable industries. Ratios must be considered in context, meaning that any ratio must be compared over time, to a competitor’s ratio, or across industries.
Which Ratios to Use and Why
In banking, we make lending decisions based on the borrower’s ability to generate and manage cash. We are all taught that there are three sources of loan repayment: 1) cash (from operations), 2) cash (from the liquidation of collateral), and 3) cash (from the guarantor’s other operations or liquidation of other collateral). It is all about cash and the key ratios for lending decisions must aim to measure the ability of the borrower to generate and manage cash.
An important understanding for lenders about financial statements is the difference between cash versus accrual method of accounting. For accrual basis, revenue is booked when earned and expenses are booked when incurred. For cash basis, revenue is booked when cash is received and expenses are booked when cash is paid. Cash and accrual methods may demonstrate very different results for the same entity. Most companies use the accrual basis of accounting, however, our lending decision must be made on a cash basis.
There are five general ratio categories and each category contains a number of key ratios. Below are the five categories and some of our favorite and most frequently used ratios for lending decisions:
- Gross profit margin (gross profit divided by sales). This is an important indicator of the general health of the company and industry. After trends in revenue are assessed, a lender needs to consider gross margin trends and compare them with competitors. The trends in gross margins can be powerful and many operators are not able to reverse declining gross margin pressures. The gross profit margin is the first ratios to indicate when differentiation fails, competition increases or technology disrupts.
- Net profit margin (earnings after tax or EBITDA divided by sales). Net profit margin is one of our favorite measures for the sustainability of the business. We seek out borrowers that are in the top quartile of the industry for EBITDA margins.
- Return on assets (profit per asset). This is a very telling ratio for industry comparisons.
- Efficiency – productivity and utilization of resources:
- Inventory turnover (COGS divided by average inventory). For industries that manage inventory, this is an important ratio. There are two important concepts in inventory management: 1) inventory valuation can be tricky and while the inventory is carried at cost on the balance sheet, once a business experiences a downturn, inventory can lose value very quickly, and 2) inventory is expensive to purchase and maintain, therefore, companies that can carry less inventory are more efficient and more likely to be profitable.
- Net sales to assets (revenue divided by total assets). This ratio is useful to compare across industries for desirable credits.
- Days receivables outstanding (accounts receivables divided by average daily sales). This is an important ratio for some businesses because it measures the ability to collect on outstandings and highlights the difference between cash and accrual accounting. For rapidly growing businesses with expanding receivables, accrual accounting can show profitability but the company is cash poor because of receivable expansion.
- Liquidity – ability to meet obligations when due with cash.
- Current Ratio (current assets divided by current liabilities). This is the standard ratio most used for liquidity management; however, we find it least useful because it assumes full book value for inventory and receivables.
- Quick Ratio (current assets minus inventory divided by current liabilities). This is an improvement to the current ratio, but also assumes full receivables value.
- Cash ratio (cash and equivalents divided by current liabilities). This is the most conservative ratio for measurement and our favorite for underwriting purposes. While bankers prefer higher liquidity ratios, there is a cost to keeping cash and equivalent on hand. Companies earn insufficient return with cash and will want to invest funds in higher-yielding assets (like property, plant, equipment, or inventory). This is where industry ratio comparison can serve the lender well in striking the right balance and understanding of market needs.
- Solvency – a measure of assets minus debt.
- Debt to asset ratio and debt to equity ratio are the old favorites. However, these ratios can be misleading if they do not adjust equity or assets to market value. Further, accounting aberrations can skew these ratios in unintended ways. For example, many companies will write-down goodwill as quickly as possible for tax purposes and in the process decrease equity. Even though the goodwill is a true and valuable earning asset such as intellectual property, marketing rights or sales contracts, the company’s debt to asset or debt to equity ratio will be low and may mislead the lender.
- Debt service charge ratio (EBITDA or NOI divided by P & I payments). This is a much better indicator of solvency than the balance sheet measures of debt to asset or debt to equity ratios. The more stable the industry, the more acceptable for this ratio to be lower. We see hundreds of loans every month from community banks across the country and the average ratio for larger credits (over $1mm) is just over 2.0X. However, the range for this ratio is from 1.1X to well over 6.0X.
- Leverage ratio (total debt divided by EBITDA or NOI). This is the gold standard of loan underwriting. The ratio is powerful because it combines a market-driven value of debt from the balance sheet and a simple cash flow proxy. This ratio explains the borrower’s ability to repay debt over a number of years from cash flow generated. Leverage ratios above 6X are considered too high for most industries. We have a calculator that will generate leverage ratios and debt service coverage ratios with very simple inputs (let us know if you would like a copy). For example assuming a standard CRE loan with 75% LTV, 7.5% cap rate, 25-year amortization and 4.00% interest rate, a borrower’s leverage ratio is 10X and the debt service coverage ratio is 1.58X.
- Cash generation – a measure of cash used, generated and managed.
- Free cash flow to sales ratio. Free cash flow is cash from operations minus maintenance capital expenditure. We are measuring the borrower’s ability to generate cash that can support repayment of debt after replacing the necessary wear and tear on equipment and building. This capex adjustment fixes the inherent issue associated with measuring cash flow with EBITDA or NOI. Used on a trend analysis, this ratio is a strong indicator of the borrower’s credit strength.
Commercial lenders are being asked to do more pre-flight analysis and preliminary underwriting. Understanding ratio analysis can be a big help in this area and can help lenders and underwriters to get to a decision quickly using fewer resources. Financial statements and notes can run hundreds of pages, but proper ratios with trend analysis can be presented on one page. A solid understanding of ratios analysis can help any commercial lender become more successful.
Submitted by Chris Nichols on September 06, 2016