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Capacity and Credit

By: Dale Van Eckhout
Former Senior Area Manager
North Dakota District Office

Cash is the lifeblood of a business. Your business won't survive without money to pay employees, purchase equipment and supplies, and to pay its expenses. The ability to obtain cash at the right time and on affordable terms is essential to your success.

The way entrepreneurs obtain cash has changed dramatically over the last 10 years. However, traditional bank financing remains a strong and viable option for most start-up and growing businesses. Before you approach a lender, it is a good idea for you to understand as much as you can about the factors that will influence the decision to approve or deny your loan request. Then, if something needs improvement, you can do so before approaching a lender.

Lenders will consider each unique situation and will look at some variation of the five C's: Credit, Character, Conditions, Capacity and Collateral.

This article will focus on "Capacity" which refers to your ability to repay the loan from the profits of your business. You must be able to show that your business will generate enough profit and cash flow to pay business expenses, principle and interest on all loans, and compensate you, the owner.

A lender will examine key numbers and ratios from your financial statements to evaluate the capacity of your business to repay a loan and what terms you will get. While these ratios are important when you are looking for financing, they are a key measurement of the health of your business in general and should be reviewed on a regular basis.

Debt-to-Income (DTI) Ratio
A DTI ratio is calculated by dividing your total monthly expenses, including loan payments, by your gross monthly income. A high DTI percentage suggests that you may have too much debt in relation to your income. The maximum DTI will vary by lender.

Debt-Service Coverage Ratio (DSCR)
This ratio shows how much cash is available to pay off debt. A DSCR is calculated by dividing your total earnings before interest, taxes, depreciation and amortization (EBITDA) by the annual principal and interest payments on all business loans, including the proposed new loan.
A DSCR of 1 shows that a business has just enough income to repay current debt. However, a lender will want to see that you also have enough extra cash to cover any unexpected expenses. While the exact DSCR requirement will vary by lender, SBA loans require a DSCR of 1.15 or greater.

Current Ratio
This is a liquidity ratio. It shows your ability to repay business debt with business cash, and cash-equivalent assets (i.e. inventory, accounts receivable and marketable securities). The higher the ratio, the more capable a business is of repaying it's loans. For example, a current ratio of 1.25 means that there is $1.25 in current assets for every dollar in current obligations.

Debt-to-Tangible Net Worth Ratio
This ratio shows how much of your business is supported by borrowed money. It is calculated by dividing total liabilities by tangible net worth. Tangible net worth equals all business assets minus liabilities minus intangible assets (goodwill and intellectual property such as proprietary technology or designs). The higher the ratio, the greater the risk assumed by creditors. Technology companies may have a very high ratio which is non-reflective of the actual business as no value can be given on proprietary assets under the definition of tangible assets.

Managing Cash Flow
Successful business owners pay careful attention to cash flow. The cash flow cycle represents the length of time that cash is tied up in business operations and unavailable for other projects. Managing cash flow means managing 1) how long inventory sits before being sold; 2) how long it takes your customers to pay; and 3) how long you take to pay your suppliers. To determine how well the cash flow cycle is being managed, lenders will review these additional ratios:

Inventory Turnover Ratio
This calculation shows how quickly the business sells its products. It is calculated by dividing average inventory by the cost of goods sold. Average inventory is the cost of inventory on hand at the beginning of the business year plus the cost of the inventory on hand at the end of the business year, divided by 2. This ratio will vary by industry, however inventory is one of the biggest assets for most businesses and if it can’t be moved out the door, it is worthless to your business and lender.

Receivables Turnover Ratio
This calculation shows how quickly you collect debt that is owed to you. It also measures how efficiently a business uses its assets. A receivables turnover ratio is calculated by dividing average accounts receivable by sales. Average accounts receivable equals the dollar amount of accounts receivable at the start of the business year plus the end of the business year accounts receivable, divided by 2. This ratio also varies by industry and you should compare to industry average. The faster collections are made, the higher the number.

Payables Turnover Ratio
The final component of the cash flow cycle is the length of time it takes you to pay your bills. The Payable Turnover Ratio is calculated by dividing total supplier purchases by average accounts payable. Average accounts payable equals the start of the business year accounts payable plus end of the business year accounts payable, divided by 2. Although you do not need to pay too quickly, a larger number may indicate that you are dependent on accounts payable to finance the purchase of inventory.

Other Considerations
Along with the above ratios, the amount, type, and stability of income are good indicators of capacity. Managerial capacity is another important factor. This includes your educational background and experience in business as well as past achievements in the industry. The quality of your references and the background and experience of your key employees will also be considered by lenders in making their decision to approve or deny your loan request.

Local Assistance
SBA's resource partners - the North Dakota Small Business Development Centers, the North Dakota Women's Business Center, and North Dakota SCORE Mentors - can help you understand these ratios. Their services are free and confidential.

Dale Van EckhoutDale Van Eckhout was the Bismarck senior area manager for the U.S. Small Business Administration from 2011 to 2017, having formerly been Business and Cooperative Program Director and District Director for USDA Rural Development. He is a Certified Economic Development Professional and has received Accreditation from the American Society of Farm Managers and Rural Appraisers. SBA North Dakota District Office can be reached at