Businesses that require funding for their day-to-day operations often resort to banks for working capital loans. Banks, however, must evaluate the borrower’s financial standing before granting them a loan. Therefore, banks scrutinise the borrower’s financial statements and assess their key metrics to determine their creditworthiness. If you’re looking for a working capital loan, it’s important to understand the key ratios analysed by banks to determine your eligibility. Let us examine the important ratios banks consider before granting working capital loans.

List of Key Ratios:

Current Ratio:-

The current ratio is a liquidity metric that gauges a company’s ability to settle its short-term obligations. Banks usually prefer a current ratio exceeding 1.5, as this indicates that the borrower can meet its existing debts using its current assets. If the current ratio is less than 1.5, it could imply that the borrower may face difficulties repaying the loan. Therefore, to enhance their current ratio, borrowers can increase their current assets or reduce their current liabilities.

Gearing Ratio:-

The gearing ratio estimates the debt amount a company has in comparison to its equity. A higher gearing ratio implies that the borrower carries a greater debt burden, which could indicate that lending to the company is riskier. Banks typically favour a lower gearing ratio since it denotes a lower risk level. Borrowers can decrease their gearing ratio by reducing their debt or increasing their equity.

Leverage Ratio:-

The leverage ratio gauges the borrower’s ability to meet its long-term obligations. This ratio measures the debt amount relative to the borrower’s equity. Whereas banks like a lower leverage ratio as it reduces the risk of default, sometimes, the borrower may need to increase its leverage ratio by raising its debt or decreasing equity.

Inventory, Debtor and Creditor Cycle:-

Banks take into account the inventory, debtor, and creditor cycle of the borrower. The inventory cycle measures how swiftly a company sells its inventory. A shorter inventory cycle is desirable as it indicates a higher turnover of inventory. Similarly, the debtor cycle measures how quickly a company collects payments from its clients. A shorter debtor cycle is preferable as it indicates lower credit risk. Conversely, the creditor cycle measures how fast a company can pay its suppliers. A more extended creditor cycle is preferable as it highlights improved cash flow management.

EBITDA Margin:-

The EBITDA margin measures a company’s earnings before interest, taxes, depreciation, and amortisation in relation to sales. Banks consider this ratio as it reveals the borrower’s operating efficiency. Therefore, banks typically favour a higher EBITDA margin since it indicates higher profitability.

Debt Service Coverage Ratio:-

The debt service coverage ratio measures the borrower’s ability to service its outstanding debt. Banks prefer a higher debt service coverage ratio as it suggests the company has adequate cash flow to service its debts.

Interest Coverage Ratio:-

The interest coverage ratio measures the borrower’s ability to meet its interest payments. Banks typically favour a higher interest coverage ratio, demonstrating the borrower’s ability to meet its interest obligations.

Fixed Assets Coverage Ratio:-

The fixed assets coverage ratio measures the borrower’s ability to cover its long-term debt obligations using tangible assets, such as property and equipment. Banks mostly favour a higher fixed asset coverage ratio as it denotes the borrower’s ability to repay long-term debts.

Asset Coverage Ratio:-

The asset coverage ratio measures the borrower’s ability to cover its debt obligations using both tangible and intangible assets. Banks consider this ratio as it provides a comprehensive overview of a borrower’s creditworthiness.

These ratios are critical for banks to assess a loan application. Banks anticipate borrowers to maintain desirable levels of these ratios and continue improving their financial health over time. Borrowers should understand these key ratios analysed by banks and take the necessary steps to improve their metrics by managing their finances efficiently. By doing so, businesses can avail themselves of working capital loans without facing any obstacles.