In this column, I'd like to drill on key performance indicators that lenders use to determine financing.
Prior to submitting your loan package, you must know the key indicators and ratios your lender will be looking at. You'll also want to know the expected performance for each ratio. Bear in mind, the expected performance will change with changes in the economic environment. The lenders will use the indicators to determine the credit-worthiness and the financial risk of making the loan.
Lenders Pay Attention to These Indicators
Typically, lenders will look at the following:
—Cash flow: The ability to service the debt and repay the loan is the single most important factor lenders will consider.
—Balance sheet and capital structure: Lenders want to know how much capital at risk or investment the owner has in the company. Make sure you include personal loans to the company in your investment number that are properly footnoted, and indicate the actual amount of loan and capital.
—Liquidity is another key measurement calculated from the balance sheet, and it directly measures the ability of the company to support its cash obligations. This measurement is commonly known as the current ratio and is calculated by dividing current assets into current liabilities.
—Current assets include all the assets that will be converted into cash within the next 12 months. Current liabilities include all obligations to be paid within the next 12- month period. The expected performance for this ratio is 2 to 1; however, home builders typically do not do very well in this measurement and lenders will generally accept a ratio of 1.5 to 1.
—Financial stability: This is typically measured by looking at the sales trend and the efficiency by which the company utilizes its resources or assets. Efficiency is measured by what is called a turnover ratio, with the asset turnover calculated by dividing total assets into the sales for the year.
—Operating performance, such as return on assets and return on equity: These measurements, or ratios, reflect both the profitability of the company as well as the efficiency by which the company utilizes its resources. As we look at the formulas for each of these measurements, we need to understand the components to be able to maximize their performance.
The formula for return on investments is almost the same as return on assets, except that it introduces leverage: the relationship of borrowed funds to owners equity, which, as it increases, will increase the return on investment as well as the risk.
Recently, banks have been tightening their loan requirements. You should talk to your banker before submitting your loan application or renewal to determine what the current requirements are so you can structure your submission accordingly.
Since 1975, Chuck Shinn Jr., a consultant and industry educator with a doctorate in business management, has improved the management skills of home builders to increase their profits, quality and customer satisfaction. He can be reached at [email protected].