Three Indicators of Creditworthiness for Your Business Clients
By Mary Ellen Biery, Research Specialist, Sageworks
Debt Service Coverage
One of the most basic measures of a company's creditworthiness is the debt service coverage ratio (DSCR), which shows a firm's ongoing ability to keep in control both debt and interest. The DSCR, defined as earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by a firm's current portion of long-term debt and interest expense, is an extremely important metric for predicting default. More than half of the banks and asset-based lenders in a recent Pepperdine Capital Markets survey said this statistic was important or very important in their lending decisions.
Given its role in lending decisions, an improvement to the DSCR can be beneficial, and it can be accomplished in a variety of ways. Cutting expenses may boost your client's EBITDA, even if debt and interest payments stay the same.
But your business clients can also improve this ratio by focusing on debt and interest expense. Short of extending the term of a loan or refinancing to lower interest expense, one effective way of tackling the debt/interest side of this ratio is to cut expenses and apply the savings toward paying principal on the debt.
"Sell things that can boost cash, such as unproductive assets", advises Sageworks analyst Libby Bierman. "These are assets that are not contributing sufficiently to the generation of income and cash flow, possibly because they are underutilized. Use the proceeds of the sale to pay off principal on your debt."
Similarly, small decreases in overhead can typically yield large cash savings over time, and the impact of those savings is compounded when they are used to repay principal, lowering not only debt payments but also interest expense. Urge your clients not to overlook things such as fraud control when trying to trim selling, general, and administrative expenses. Fraud can pad expenses and inflate a company's cost of sales.
Net Income to Sales
The net income to sales ratio is a fundamental measure of how profitable your business clients are. There are three possible fixes for low profitability, according to the book Financial Intelligence for Entrepreneurs. One option – cutting operating expenses – can be more of a short-term fix. But authors Karen Berman and Joe Knight caution that cost cuts (such as layoffs) can sometimes backfire, or they may only serve to postpone "the day of reckoning" that exposes deeper strategic issues at the company.
Two of the fixes – increasing profitable sales and lowering production costs – take time to identify and implement. Lowering production costs often involves finding ways to get raw materials or key services more cheaply or to use less of them. Or it can mean identifying new, more efficient methods of producing a good or providing a service.
To increase profitable sales, your clients "have to find new markets or new prospects, work through the sales cycle, and so on", according to Berman and Knight. Lowering the cost of goods sold typically involves studying the production process, finding inefficiencies, and implementing changes, they say.
Converting browsers into buyers by scheduling operational duties (such as receiving) to take place at a time customers are not likely to need assistance is one way to optimize sales. Another low-cost option for boosting sales: Urge clients to work on getting free publicity when possible by contributing to a newspaper or magazine article on a subject associated with the business. Often, this can build credibility and name recognition, which can potentially attract additional customers. Or tell them to seek insight from customers or outsiders to help grow a company's sales. Focus groups, or even a suggestion box, might generate ideas that are simple to implement, or they might prompt a longer-term change in strategy to optimize sales.
Debt to EBITDA
EBITDA is widely used as a proxy for pre-interest, pre-tax cash flow from operations. Comparing EBITDA to a company's assets helps show profitability – how much income, or cash, a company can generate from its equipment, property, and other assets, according to Lawrence Litowitz, a partner at strategic advisory firm The SCA Group LLC.
One way to improve this ratio is to focus on the numerator to increase your EBITDA. Boosting EBITDA typically involves either raising revenues (without a commensurate increase in expenses) or cutting expenses.
Raising revenues can involve better planning, such as getting ready early for holiday sales, or it can involve improving business offerings by gaining insight from customers through market research or other methods of customer input. "Reducing friction points – learning curves, waiting periods, paperwork, delivery charges, and so on – in the customer experience will encourage them to use and recommend a business more often", according to Bierman. However it is done, increasing sales volume allows for better coverage of fixed costs, which can lead to higher profitability.
Cutting expenses is often the focus of efforts to boost EBITDA, because those savings may fall straight to the bottom line. One way for your clients to cut expenses involves seeking out multiple qualified vendors to get the best prices through competition while maintaining quality. "If the business is not continually reviewing and updating its existing and potential vendor lists, it may overspend on supplies or inventory", said Michael McNeilly, director of advisory services at Sageworks.
The Better Business Bureau offers several suggestions for businesses to cut back on spending, which the agency notes has the added benefit of freeing up more cash. Ideas include increasing the company's insurance deductible (although it might be wise to add some of the premium savings to an emergency fund) and reviewing service plans for basic business services, such as telephones, Internet, and equipment leasing.
Sometimes it helps to benchmark the financial performance of your business clients to that of peers to guide efforts to improve EBITDA to assets. Doing so can help identify areas where your client lags in net profit margin, for example, or inventory turnover.
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About the author:
Mary Ellen Biery is a research specialist at Sageworks, a financial information company and provider of the Business Credit Report by Sageworks. She is a veteran financial reporter whose works have appeared in The Wall Street Journal and on Dow Jones Newswires, CNN.com, MarketWatch.com, CNBC.com, and other sites.