3 Financial Ratios Your Banker Will Look In Your Term Loan Request — For Sri Lankan SMEs
Being SME business owner who approaches a bank for a loan, by know most of you realize it’s not easy task. Only by making profit in past, submitting business plan and/or offering security bank won’t lend money. In reality bank will analyze several area before lend money. But most importantly, SME must achieve good financial scoring to secure a loan.
Financial ratios are essential metrics use to measure performance of business and allow banks to assess risk. There are several categories of financial ratios that are used by banks to evaluate business. The major categories measure profitability, liquidity and debt ratios.
Although ratios don’t make sense to the average SME, the bank will rely heavily on just 3 ratios to get a good picture of your business, so it is important for you to understand how to calculate them and more importantly what they mean and how you can improve before approach a bank for loan.
Profitability Ratios
It’s indication of current profitability, how capable or ability of business to generate profits from core operations and business trends. For most of these ratios, having a higher value relative to a competitor’s ratio or relative to the same ratio from a previous period indicates that the business is doing well.
These ratios include gross profit margin which essentially is the gross profit (sales revenue minus cost of sales) divided by the sales revenue. Simply bank can identify whether SME generating sufficient sales to cover costs. This ratio provides some insight as to the pricing sufficiency, production/inventory costs and controls and depending upon the industry.
The net profit margin factors in the impact operating expenses such as administrative and selling costs and provides an indication as to whether the business is managing its operating costs properly.
Banks use the return on assets and return on equity to judge whether SMEs are making enough operational profit from their assets. Profitability is also important to the concept of solvency and going concern. This measure help bank to understand efficiency of SME and for investment comparisons.
Liquidity Ratios
The liquidity ratios provide an indication SMEs ability to pay short-term obligations. Liquidity mean as SMEs capability to sell assets quickly to raise cash. Adequate liquidity is healthy financial indications for SMEs.
These ratios include the current ratio, which measures SME’s ability to pay off its current liabilities (accounts payable, taxes, and the current portion of term debt) with its current assets (cash, receivables, and inventory). The higher the ratio, the better the SMEs liquidity position.
A more accurate measure is the quick ratio, which only uses the liquid assets, excludes inventories from its current assets in order to pay short term liabilities.
Debt Ratios
The debt ratios determine risk to bank based upon its profits in relation to its debt payments. The debt ratio indicates financial stability of the SMEs.
The debt ratio is the debt capital divided by the SMEs’ total assets (current and non-current assets). This ratio shows how much a SMEs relies on its debt to finance its assets. The lower debt ratio, the more likely SMEs to be granted a loan.
Debt Service Coverage Ratio is incredibly important when applying for a loan. Debt service coverage ratio calculated by dividing annual net income by your annual loan payments. By calculating this ratio, bank determines how much breathing space they have or determine whether SMEs can handle requested loan payments.
There are additional ratios and factors that businesses and lenders consider depending upon the type of business and size of loan. If Sri Lankan SMEs have a good understanding of these three ratios, SMEs will be approach the bank with confidence. Good luck!
Being banker by profession, I personally believe, the partnership with right business banking is significance for success.
