When evaluating a company’s ability to repay debt, a bank typically evaluates the company’s debt-coverage ratio. This ratio divides the company’s net cash flow from operations by the total debt payments (principle plus interest) to determine the number of times operating cash flow can service or repay the debt.
In equation form: (Earnings before Interest, Taxes, Depreciation & Amortization – Maintenance Capital Expenditures) / (Annual Principle + Interest) An output of 1 indicates that the business provides just enough cash flow from operations to cover principle and interest payments. Since cash flow is also required for things such as a return on investment to ownership, research and development and growth a lender will require a ratio greater than 1 in order to assure the long term viability of the business.
A ratio of 1.15 to 1.25 (15% to 20% excess cash flow over annual principle and interest payments) is typically required by a lender when calculating the debt coverage ratio using historical figures. A ratio of 1.25 to 1.50 (25% to 50% excess cash flow over annual principle and interest payments) is typically required when calculating based on projected figures.