Are you looking at applying for a business loan? Before you do so, read this article to understand what banks typically look for before giving loans.
Banks typically consider several metrics when evaluating loan applications from small and medium-sized enterprises (SMEs) and startups. These may include:
Credit history and credit score: Banks will review the credit history and credit score of the business owner(s) and the business itself to assess the likelihood of default.
Collateral: Banks may require collateral, such as equipment or real estate, to secure the loan in case of default.
Revenue and cash flow: Banks will review the revenue and cash flow of the business to assess its ability to repay the loan. They may also look at the business’s financial statements, such as income statements and balance sheets.
Business plan and industry: Banks will review the business plan to assess the likelihood of success, and may also consider the industry in which the business operates and the overall economic climate.
Time in business: Banks may give more favorable terms for the loan if the business has been in operation for a longer period of time.
Ownership and management experience: Banks may also want to review the background and experience of the business owner(s) and management team.
It’s worth noting that the criteria can vary by institution and the loan itself and can also depend on if the loan is secured or unsecured.
Business loan performance metrics analysis
In addition to the metrics mentioned above, banks may also consider a business’s performance metrics when evaluating loan applications. These may include:
Sales and revenue: Banks will want to see the business’s current sales and revenue figures, as well as projections for future growth. They may also look at revenue trends over time.
Gross margin: Banks will want to see the business’s gross margin, which is the difference between revenue and the cost of goods sold. A higher gross margin indicates that the business is generating more profit from its sales.
Operating margin: Banks will also want to see the business’s operating margin, which is the difference between revenue and all operating expenses. This metric gives an idea of how efficient the business is at controlling its costs.
Asset turnover: Banks may also look at the business’s asset turnover ratio, which measures how well the business is using its assets to generate sales.
Return on assets (ROA) and return on equity (ROE): These ratios measure the profitability of a business and how well it’s using its assets and shareholders’ equity to generate profits.
Debt-to-equity ratio: Banks will also look at the business’s debt-to-equity ratio, which compares the business’s total liabilities to its total shareholders’ equity. This ratio gives an idea of how leveraged the business is, and a high debt-to-equity ratio could be a red flag for banks.
Debt service coverage ratio: This measures a business’s ability to meet its debt obligations.
It’s worth noting that depending on the lender, the type of loan and the size of the business, the weight given to each of the above mentioned metrics will vary.
Important Financial Ratios
Below are some examples of financial ratios that you can use to determine the health of your business.
In these examples, “Net Income” refers to the company’s net profit or net earnings, which is the company’s total revenue minus all of its expenses (including cost of goods sold, operating expenses, taxes and interest).
Net income is a measure of a company’s profitability and is typically used in financial ratio analysis, such as calculating ROA and ROE. It is the net figure after all expenses, including taxes, and is found on the company’s income statement.
Revenue is the total amount of money a company brings in by selling its products or services, and it is the top line number on the income statement, in other words the start of the income statement. Revenue does not take into account expenses, taxes or other deductions and is not the same as net income.
So to clarify, when calculating ROA and ROE, the “Net Income” input refers to the company’s net profit or net earnings, not its revenue.
Return on Assets (ROA) Calculator
healthy return on assets (ROA) depends on various factors, such as the industry in which a company operates, the company’s size, and its overall financial health.
Generally speaking, a high ROA indicates that a company is generating a lot of profit from its assets and is effectively using its resources. A ROA of 10% or higher is generally considered to be good, indicating that the company is earning a healthy profit on its assets.
However, it’s important to note that industry and sector averages for ROA can vary greatly and so it’s always important to compare the ROA of a company with its peers and industry benchmarks.
For example, companies in the technology sector tend to have a higher ROA because they require less investment in physical assets like buildings, factories and equipment. On the other hand, companies that operate in heavy industries such as construction, manufacturing or mining tend to have lower ROA.
A company’s management could also be more efficient in using their assets to generate more income, in this case a higher ROA can be the outcome.
It’s also important to note that a consistently high ROA is not always a good thing as it can indicate that a company is not investing enough in growth opportunities. A healthy balance of reinvestment for growth and generating returns on assets is usually the best approach.
Return on Equity (ROE) Calculator
Return on equity (ROE) is a financial ratio that measures a company’s profitability in relation to the amount of money that its shareholders have invested in the company. Like ROA, it’s a key metric that investors use to evaluate a company’s performance and compare it to its peers and industry benchmarks.
A high ROE indicates that a company is generating a lot of profit from the money that its shareholders have invested, and is effectively using the capital it has raised. A ROE of 15% or higher is generally considered to be good, indicating that the company is earning a healthy profit on its shareholder’s equity.
However, similar to ROA, the industry averages for ROE can vary greatly, for example, a retail business may have a lower ROE than a technology startup because the later one may have lower operational costs.
It’s also important to note that a consistently high ROE can indicate that a company is not using its shareholder’s equity efficiently. In this case, the company may not be investing enough in growth opportunities or may be returning too much of its profits to shareholders instead of reinvesting it back into the business.
To have a better understanding of a company’s performance, it’s best to compare its ROE with that of similar companies and its industry average.