How does a bank calculate whether you can repay a loan before granting it?
There is collateral and there is profit, yet the bank suggested extending the loan term. Why? Using a furniture workshop as an example, we calculate how many times cash flow covers debt payments and check it ourselves.
Javlon, the owner of the "Zarafshon Mebel" workshop, asked a bank for a 300 mln soum loan for a new machine tool and chose a 3-year term. The collateral is sufficient and the workshop operates at a profit. Even so, the loan officer suggested a 5-year term. Javlon did not understand why.
The reason comes down to one question: is the workshop's cash enough for the loan payments each year, and how much of a cushion is left?
What does the bank look at?
Credit history, collateral and the financial statements matter. But in the end a loan is repaid not by collateral but by cash flow. Paragraph 10 of NAS No. 9 also calls cash flow from operating activities the key indicator of sufficiency for repaying debts, maintaining capacity, paying dividends and making new investments.
The coverage ratio
Banks often calculate this ratio (its English abbreviation is DSCR):
Coverage ratio = annual cash flow before debt payments ÷ debt payments during the year (principal + interest)
- Less than 1: the cash is not enough for the payments.
- Equal to 1: the cash is exactly enough, with no cushion at all.
- Greater than 1: cash is left even after the payments.
Each bank sets the acceptable level for itself in its internal procedures. But the logic is the same: the higher the ratio, the more reliably the loan will be repaid even in a year when sales fall.
The "Zarafshon Mebel" calculation
Amounts in mln soum, hypothetical: - annual cash flow before debt payments: 360; - annual payments on the existing lease and an old loan: 120; - new loan: 300, 24% a year, principal repaid in equal portions (differentiated); - for simplicity, interest for year 1 is calculated on the balance at the start of the year: 300 × 24% = 72.
| Option | New loan: principal + interest (year 1) | All debt payments | Ratio | If cash flow falls by 20% (288) |
|---|---|---|---|---|
| 3 years | 100 + 72 = 172 | 292 | 360 ÷ 292 = 1.23 | 288 ÷ 292 = 0.99 |
| 5 years | 60 + 72 = 132 | 252 | 360 ÷ 252 = 1.43 | 288 ÷ 252 = 1.14 |
In a normal year both options pass. But in a year when orders fall by 20%, under the 3-year option the cash is not enough for the payments (0.99). Under the 5-year option a cushion remains (1.14). This is exactly what the loan officer saw.
The longer the term, the lower the annual payment, but the more total interest is paid. That is the trade-off between the two.
Where should the figures come from?
- The statement of cash flows. Under paragraph 6 of NAS No. 9, cash flows are divided into three categories: operating, investing and financing activities. The main source is the operating activities section.
- Where is the interest? Under paragraph 24, interest paid may be shown as a financing cash flow. If interest is included in the operating section of your statement, add it back to the numerator, otherwise it will be counted twice.
- All debts. Leases, borrowings from a partner and other loans also go into the denominator.
Practical tips
- Calculate the ratio yourself before going to the bank. That way you go with a well-founded proposal on term and amount.
- Add at least one "bad year" scenario (sales 10–20% lower).
- In a seasonal business, calculate monthly rather than annually: surplus cash in summer does not automatically cover a payment in winter.
- Base the forecast on actual figures from past years. The bank does the same.
Test yourself
5 questions on this topic: pick an option or reveal the answer.
The part of a long-term bank loan transferred to the current portion (6950) was repaid from the settlement account. What journal entry is made?
An entrepreneur took a bank loan of 10 000 000 soum: 1 year, 20% simple annual interest, interest and principal paid at the end of the year. When issuing the loan the bank immediately withheld a one-off fee of 2% of the amount (hypothetical terms). What is the approximate effective annual cost of the loan relative to the money actually received?
Interest previously accrued on a bank loan was paid from the settlement account. What journal entry is made?
According to the bank statement, account 5110 "Settlement account" had an opening balance of 15 000 000 soums at the start of the month, debit turnover during the month of 40 000 000 soums and credit turnover of 32 000 000 soums. What is the closing balance at month-end?
"Arnasoy kimyo" LLC deposited 10 mln soum from its settlement account into a chequebook. The bank paid 6.2 mln soum on the cheques; another cheque for 1.5 mln soum was issued to a supplier but has not yet been presented to the bank for payment (hypothetical amounts). Under paragraph 232 of NAS No. 21, what is the balance of account 5520 "Checkbooks"?
Answered: 0 / 50 of 5 correct
All tests →See also
Sources
- NAS No. 9 "Statement of Cash Flows", paragraphs 6 and 10 · three categories of cash flows; cash flow from operating activities is the key indicator of sufficiency for repaying debts and other needs
- NAS No. 9, paragraph 24 · interest paid may be classified as a financing cash flow
- Example, interest rate and calculations · compiled by the author, hypothetical