financing expectations from bank

Financing: what should (and can) you expect from your bank?

Financing: what should (and can) you expect from your bank?

October 3, 2022

When the economy gets weaker, it is good to look at financing options. In other words, taking a trip to the bank. But what can you expect when it comes to a (subsequent) interest rate proposal? And what about the financing risks? What should (and can) you expect from your bank?

Financing

At the moment, inflation is skyrocketing. The European Central Bank (ECB) is aiming for a long-term inflation rate of 2%. To reduce the current high inflation rate, it is adjusting its interest rate policy. The second big interest rate hike was recently instituted, at 0.75 percentage points this time around. Further interest rate hikes are expected. What does this mean for your business financing?

How does the bank assess your financing?

There are three main pillars. Firstly, is there faith and trust in the company to be financed? Here, they look at the entrepreneur, the track record, the industry the company is operating in and whether there is confidence in the business model. Secondly, the earning capacity is assessed. In other words, is cash being generated with sufficient certainty to meet the financial obligations, repayments and interest charges? Thirdly, the bank looks at the collateral, should the earning capacity ultimately prove insufficient and financing has to be withdrawn.

The bank always follows this order when providing new financing. This means that some industries and entrepreneurs are denied financing even if the earning capacity and collateral are acceptable. Collateral is the last element in the assessment. When confidence in the company and the entrepreneur is high and there is sufficient cash-generating capacity, collateral is less important. There are also always state guarantees in that situation.

Existing financing and interest rate reviews

The collateral pillar becomes increasingly important. Is revenue falling and are risks increasing for the bank? Then collateral comes into play. So make sure that this is in order. The bank will not simply extend financing based on collateral. But it does provide peace of mind, if the bank does not have to stop financing due to feared risks. Interest rates for existing financing are expected to rise. This is due to rising interest rates and margin adjustments the bank applies based on its risk profile. And yes, a bank is allowed to unilaterally increase the margin. Even if there is a fixed interest rate. The general conditions provide for that option.

Finally. always aim for the ratios mentioned above. As long as these remain favourable, there is no reason to change the margins. But many companies accumulated significant debt during the recent covid-19 crisis. On top of that, we now have the energy crisis and rising prices. So for many companies, profits are under pressure and the need for financing is increasing. This in turn weighs on the ratios, making interest rate rises inevitable for many companies. However, do not just take every increase at face value. Be critical, make comparisons and if necessary consult with a different (alternative) financial institution.

Commonly used bank ratios

During assessments, banks use ratios. The most commonly used ratios are as follows:

  1. DSCR (debt service coverage ratio): free cash flow divided by total interest and repayment obligations. This provides insight into the extent to which the company can meet its financing obligations. The bank often wants a minimum DSCR of 1.2. In short, you are able to pay 1.2 times the financing obligation using the free cash flow.
  2. Leverage ratio: the net senior debt position divided by EBITDA. Here, EBITDA is seen as the available annual cash flow. The ratio shows how many years it will take for the net senior debt position to be repaid from the annual gross cash flow (before investments). The bank will often be willing to finance 3 to 4 times EBITDA. Note that the net senior debt position also takes into account other non-bank debt and free cash that can reduce the net senior debt position.
  3. The bank uses the LTV ratio (loan to value) for assessing corporate real estate financing specifically. The LTV ratio measures the loan amount against the appraised value of the property. Depending on the type of commercial property and the banking institution, an LTV ratio of 60% to 80% of the appraised property value is assumed.
  4. Solvency ratio: the adjusted equity (guarantee capital) divided by the balance sheet total. In other words, it is not based on visible equity according to the financial statements. The bank applies adjustments to the equity. For banking purposes, for example, any goodwill paid in a share transaction is deducted from the equity and total assets. Subordinated debt to the bank is added to equity. The financing agreement usually explains how the guarantee capital is determined. The solvency ratio provides insight into the company’s ability to meet its long-term obligations. We also call this resilience: to what extent you are able to absorb any setbacks. Depending on the type of company, the bank uses solvency standards. An indicative standard for different types of companies is presented below.   
  5. Liquidity ratios: current assets (inventory, receivables and liquid assets) divided by current liabilities. A liquidity ratio gives an indication of whether a company can meet its liabilities in the short term. There are two types of liquidity ratios: the current ratio and the quick ratio. The quick ratio is a refinement of the current ratio. This calculation does not take into account current assets that cannot be quickly converted into cash. This includes stocks with a low turnover rate, for example. For the current ratio, the bank uses a standard of 1.2 to 1.5, and for the quick ratio a standard of 1. Below ‘1’ essentially equates to an immediate shortage of liquid assets.

 

The bank uses these ratios to assess whether or not to provide financing at all. But they are also used to help determine the interest rate. This is a very opaque process, even for bank employees. Banks use systems that involve entering numbers and ratings. After that, an interest margin comes out of the black box. One thing is certain: more risk means a higher interest margin. For this reason, it is always wise to submit financing requests to several banks whenever possible. That will give you options to compare and choose from.

Do you have any questions about financing options and risks?

Please do not hesitate to get in touch with your dedicated contact person at Joanknecht or one of our recovery advisors listed below.

forensics recovery advisors

Frank Driessen | +31 (0)40 240 9438 | fdriessen@joanknecht.nl

Ronny Buiting | +31 (0)40 240 9415 | rbuiting@joanknecht.nl 

Max Broekhuizen | +31 (0)40 240 9479 | mbroekhuizen@joanknecht.nl



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