Use Accounting To Communicate With Your Stakeholders
Running a privately held business is adventurous, exciting and risky. It is fun to be an entrepreneur and to interact with a diverse group of advisers and associates as you conduct business. If you are among the many businesses utilizing bank financing, one of these individuals needs to be a sharp commercial lender.
Commercial lenders, also called Business Bankers, deal specifically with the businessmen and women using their hard-earned capital to make investments for the future. By lending capital to the entrepreneur, the banker is taking a partnership role in the success of the local business. An entrepreneur “trades” their assets (collateral) for the bank’s capital (loan) and both sides work for a profit from which the loan is repaid.
In any partnership, communication is key
Regular communication with your banker about the vision, successes and challenges helps to smooth the inevitable rough spots. A good commercial lender will value the client relationship and understands that growing local businesses is good for the bank, entrepreneurs and community.
Communicating with your banker needs to include more than just conversations about how sales, it needs to include numbers, specifically financial statements.
Anyone who has applied for a mortgage knows banks (and their regulators) need tax returns, personal financial statements and credit reports to monitor the success of their investments. On the commercial side this is a constant flow of information from the accountants and entrepreneurs to the banks about the performance of their loans.
A commercial banker uses financial statements to monitor and advise the business. Often, there are boundaries (covenants) to safeguard the business from excessive debt or cash crunches. Of the dozens of ratios being watched by a banker, here are three of the most common
The 3 Ratios Your Banker is Watching
1. Debt Service Coverage Ratio
This is possibly the most important ratio being watched by your lender and is critical to a business surviving. This ratio is not calculated the same way by all banks. It tells the bank the business can pay back the loan with cash generated by the business.
To calculate this ratio, calculate the Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) and divide this number by the required principal and interest payments to the lenders. This number needs to be higher than 1.0 to pay back debt and most banks have policies of 1.25 (often expressed as a percentage: 125%). (Because it can vary wildly, banks often use an average to find the trend.)
2. Current Ratio
The current ratio simply lets the bank know the business has enough funds to pay for its liabilities in the short term. The current ratio is calculated by dividing the current assets by the current liabilities. These are assets and liabilities expected to be used within one year. Current assets include cash, inventory and accounts receivable.
Current liabilities include an operating line, maturing long term debt and accounts payable. Each bank has a minimum requirement for their borrowers. This ratio needs to be above the bank minimum.
3. Leverage ratio
The leverage ratio tells the banker how “leveraged” the business is, or how much of “other people’s money” is used to run the business. Two popular numbers for this are the Debt to Equity ratio and the Debt to Asset. The total liabilities of the company are divided by either the equity in the company or the assets of the company.
These three ratios are by no means exhaustive but they are extensively used by virtually every bank and banker. They will assist you in communicating with your banker, which is the key to keeping the relationship strong and funding available. Knowing what the bank wants can help you prepare for questions they have not asked.