If you want to write a business plan for a bank loan, you have to tailor your proposal for the bank. What’s most important for a bank? Getting their loans paid back.
A loan to your business is an investment for the bank. They’re betting that you’ll pay them back, with interest. The bank won’t be in business long if it makes bad investments.
The challenge for a bank is to figure out which loans are good or bad investments.
Banks have developed complex models and grading systems to help them figure out the odds of you paying them back. The grades these models churn out affect the bank’s decision to lend you money, the interest rate they’ll charge, and the structure of the loan.
So, what are the most critical parts of these grading systems? Your company’s Debt Service Coverage Ratio and Collateral Coverage Ratio.
The Debt Service Coverage Ratio
Your business’s ability to repay a loan is determined by a ratio between your free cash flow and your debt service. This ratio is called the Debt Service Coverage Ratio.
So, what is free cash flow? It’s the amount of money your company will have to repay debt. Most banks use a financial calculation called EBITDA to determine free cash flow.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
To calculate it, you take your net income and add back interest expense, income taxes, depreciation expense, and amortization expense.
Your debt service is the total amount of money you’ll to the bank for the loan. It includes both principal and interest payments.
To get the Debt Service Coverage Ratio (DSCR), you divide EBITDA by the amount of principal and interest payments you made.
Okay, now that you know how to calculate the DSCR, let’s talk about what result is considered acceptable.
You’ve probably realized that anything under 1.00x means you can’t pay back the debt. That doesn’t mean that anything over 1.00x is good, though. Generally speaking, most banks want to see a minimum of 1.20x or 1.25x debt service coverage ratio.
So, what does all of this have to do with your business plan? Well, if you want to show that you can pay back your loan, you’ll want to make sure your projections can realistically hit a 1.25x DSCR.
Is there some wiggle room? Sure, every bank is different! But if you don’t have an established loan relationship with a bank, you’ll have a tough time with a DSCR below 1.2x.
The SBA 7(a) loan program gives a bit of leeway on the Debt Service Coverage Ratio. Depending on the bank loaning the money, you could potentially have a DSCR of 1.15x and get funding.
Collateral Coverage
Collateral is one of the other vital items a bank will look at.
Like I said earlier, the bank wants to get paid back. It would prefer to be paid back by regular monthly payments.
Of course, your business is going to be successful, and they shouldn’t worry about that!
Just in case, though, the bank will take all of your business assets as collateral. If your business goes under and can’t make loan payments, the bank will sell your assets to get their money back.
So, to figure out if they should give you a loan, they’ll see if the total value of your assets adds up to your loan amount. The result is the Collateral Coverage Ratio.
Assets Value ÷ Loan Amount = Collateral Coverage Ratio
Banks aren’t in the asset selling business and don’t expect to get the full value of the assets if they have to sell them.
They’ll want to sell them quickly. That means at a discount. So, they’ll lower the book value of your assets when figuring out the collateral coverage ratio.
Every bank will lower the value of different kinds of assets by different amounts.
The value of your accounts receivable would typically be reduced by 15% to 25%. Inventory and equipment may be reduced by 50%. Furniture and fixtures may be decreased by as much as 90%.
If a bank takes real estate as collateral, in most cases, it will have to get the real estate appraised. Just a heads up, you’ll probably be paying for the appraisal.
The bank may still reduce the appraised value of the real estate by 20% to calculate collateral coverage.
Your collateral coverage ratio should equal at least 1.00x.
Where to Present Your Ability to Repay and Collateral Coverage
Okay, now you know you need to show your debt service and collateral coverage ratios and how to calculate them. But where should you feature them in your business plan to get the bank loan?
The first place you’ll want to point out your killer is in the executive summary. Point them our right up front in your financing request.
The banker will appreciate that you’ve calculated them. They’ll also keep reading your plan knowing that, at the very least, you hit the ratios his credit officer wants to see.
Another great place to include these ratios would be in the financial section of your plan. I would preset everything in tables to make it easy to see how you calculated the ratios.
If you’re an established business, you’ll want to show your debt service coverage calculation for your last fiscal year, as well as your forecasted years.
You can create a table that presents everything clearly or mention your ratios in the paragraph outlining your expected performance.
What if Your Ratios Aren’t Good?
If you’ve calculated your ratios and they came out less than the recommended minimums, you’re going to need to reevaluate.
One option would be to reduce your loan request if possible. If you have some flexibility here, a small reduction in the loan amount could get you to the minimums.
You could also make your projected performance a bit better. Of course, this isn’t the best option if bumping up your projected revenue or cutting expense figures aren’t realistic.
If the collateral is the issue, take a look at an SBA program, like the 7(a) loan program. You can also consider non-traditional lenders that have lower thresholds for debt service and collateral coverage.
Finally, if you can make up a portion of your cash need with equity, either your own money or with an investor’s funds, you can lower the loan amount.
