As a result, many companies have turned to their lending institutions to take out new loans to help them get through the crisis.
I want to follow up on the topics I’ve covered in other blog posts on cash flow and working capital . I want to focus on the role of different types of business financing as well as the three financial ratios that every business owner should be monitoring to ensure their long-term financial health in the wake of the COVID-19 crisis.
3 Types of External Financing for Businesses
Overall, there are three types of external financing:
Short-term operating credit line
Long-term debt financing
Long-term equity financing
An operating line of credit can help you cope with daily fluctuations in cash flow. This volatility comes from the timing of cash inflows from customers and cash outflows (expenses). These daily fluctuations are difficult to control because of the difficulty in predicting cash inflows. Your bank understands this and tolerates these fluctuations, as long as you are not always overdrawn.
Long-term financing is provided in the form of cash inflows from investors (equity financing) or lenders (debt financing) and is considered long-term financing because repayment extends over more than one year.
Long-term financing is typically used for the following purposes:
seize profitable growth opportunities
provide liquidity to support long operating cycles
support the acquisition of fixed assets
Businesses have had to draw on their lines of credit due to the shutdown or slowdown caused by the pandemic. To ensure they have enough cash to stay in business, various levels of government have implemented financial relief measures in the form of long-term liabilities.
Create budgets to guide you through recovery
Many of these long-term loans are offered in partnership student database with private lenders and must be obtained by contacting your primary financial institution.
When you apply, banks will ask you for a cash flow plan . Your lender may also ask you for a projection for a period of 6 to 12 months.
These projections establish expected flows on a monthly basis and provide a better understanding of financing needs. They also indicate to lenders and investors how you envision the recovery.
To help guide you through this, we suggest you look ahead 12 months and begin creating budgets and plans for the duration of the COVID-19 Relief Loan period .
You will have a clear picture of your financial health and ability to repay and will begin to take the necessary steps to stay on track. You will benefit from greater peace of mind, because you will have quantified the uncertainty. In this way, you will increase your chances of obtaining a loan.
3 Leverage Ratios to Monitor Your Long-Term Financial Health
One of the best ways to ensure you can repay your loan is to closely monitor your leverage ratios.
These give you an idea of the long-term solvency of your business and the extent to which you use long-term debt to support your business.
Three ratios are particularly important when applying for a loan.
1. Debt/equity ratio
Your debt-to-equity ratio is measured by dividing your total liabilities by the company's shareholder equity . You can also use our online calculator .
Banks closely monitor this indicator to assess your ability to repay your debts. Debt capacity demonstrates both a company's ability to repay its current debts and its ability to raise funds through new debt, if necessary.
The higher a company's debt-to-equity ratio, the more leveraged the company is. When revenues decline, highly leveraged companies are more likely to miss debt payments. They are also less able to take on new debt. Generally, the debt-to-equity ratio should not be higher than two to one, but it varies by industry standards.
2. Debt service ratio
The debt service ratio measures a company's ability to make its debt payments when due. It is calculated by dividing a company's earnings before interest, taxes, depreciation and amortization (EBITDA) by its interest and principal payments.
Essentially, the debt service ratio indicates how much money a company generates for every dollar of principal and interest owed. This ratio should not be less than 2, which means that your EBITDA should be able to cover both interest and principal twice over.
3. Debt ratio
The debt-to-asset ratio, or debt-to-total-assets ratio , indicates the percentage of a company's assets that have been financed by debt specialists. A high ratio indicates a heavy reliance on debt capital and could be a sign of financial weakness.
The debt-to-total assets ratio is mainly used to assess a company's ability to raise funds through new debt. To make this assessment, the ratio is compared to that of other companies in the same industry.
The debt-to-total assets ratio is calculated by dividing a company's total debt by its total assets. You can also use our online calculator .
Stick to your operational and cash flow plan
Finally, as businesses recover from the crisis, I want to stress the importance of sticking to your operational and cash flow plans. Don’t get distracted by opportunities that seem profitable. They all need to be evaluated based on the profits they can bring to your business.
Keep a close eye on your cash inflows and outflows and don't wait until it's too late to apply for financing.
