Instructor Blog - Credit College - Commercial Business

Q: Do most lenders calculate a personal debt service coverage by applying business and investment debt after available cash to service business debt is calculated?

A: It seems to be common practice in the industry to combine business and personal cash flow to estimate cash available to service company debt. In doing so, the personal cash flow amount that is added to business cash flow is after accounting for personal debt service.

Once a lender has computed the combined cash available to service business debt, it can then relate that amount to debt service to get an estimate of debt service coverage.

The problem with using personal cash flow is that it is not a reliable number because many of the expenses are guesses, at best, especially the estimate for cash living expenses.  The living expense estimate is virtually impossible to verify. Lenders tend to underestimate personal living expenses, which, in turn, results in an overestimate of personal cash flow available to service company debt.

Q: I believe that it needs to be taken into account that with the super-conservative methodology stated in the presentation, that these terms might make the borrower very unhappy. Perhaps that needs to be taken into consideration, since our borrower can shop other banks. Unless we can make up for our covenants through interest rate, etc., we can't afford to be that much more conservative that competitor financial institutions if we are to offer market rates.

A:  Our objective is to lay out the facts. Every lender decides on its underwriting standards, which may totally disregard all other analytical messages, but at least it understands the problems it may encounter.

For example, whether Larry Crevin will agree to maintain a certain amount of his personal assts in assets that the lender defines as liquid depends on the competition and Larry Crevin. If the lender required that he maintain at least $1 million in liquid assets, that would be sufficient to pay off all of the company’s interest bearing and would not require a change in investment focus, since he has over $2.6 million in liquid assets. And to maintain at lease $1 million in liquid assets would seem to be a reasonable requirement. If Larry Crevin refused, then the lender could decide if the company would still be worth pursuing. Again, it is up to the financial institution to determine its underwriting standards. Our aim is to lay out the risks and possible mitigants, which we address in detail in Session 7.