Loan to Security Ratio: a Worked Example

A business loan is meant to be repaid from the business's cash. The security is the second way out: what the bank recovers if the cash stops. Read that way, a valuation is not what an asset is worth to its owner but what the bank would collect by selling it, after a default, without the business that made it useful. A freehold factory loses some of its value in that sale. A specialised machine can lose most of it, and some assets have no buyer at all.

The ratio puts the whole relationship on one line. Every facility the bank has given the customer goes on top: term loans, the overdraft, bonds issued on its behalf, the risk on its hedging lines. Every asset the bank holds goes underneath, each at its lending value. The result says how much of the exposure the security answers for, on the assumptions the bank has chosen. Banks name it differently, as security cover or a security shortfall, but the arithmetic is the same.

Four choices decide the answer. The first is the exposure. A bank commonly counts facility limits rather than balances, because a customer in trouble draws its overdraft to the limit, and counts contingent lines too: a performance bond at its face amount, a foreign-exchange line at a credit equivalent for what the bank could lose on it. The second is the valuation: which valuer, what date, and whether it is market value or a forced-sale value. The third is the lending ratio for each class of asset, set in the bank's own credit policy and differing from one bank to another by asset type, location and how specialised the asset is. The fourth is what ranks ahead: another lender's mortgage, an equipment financier's purchase money security interest in New Zealand or Australia (in the UK such equipment is more often on hire purchase, and not the borrower's to charge), or the preferential claims that rank ahead of a general security over receivables and stock in insolvency.

A timber processor, constructed for this page like every figure in it, has a US$2.4m term loan, an overdraft with a limit of US$0.6m of which US$0.2m is drawn, and US$0.15m of performance bonds issued by the bank. The bank holds a first mortgage over the mill site and a general security agreement over the company. The lending ratios below are the example's, not a market norm or any bank's policy.

On balances the processor is covered. On limits it is US$0.19m short, which is the reading many banks use, because the undrawn overdraft is the part most likely to be drawn when trading gets hard. Then the file shows that a new saw line, US$0.9m of the plant valuation, was bought on an equipment loan from another financier, which has US$0.3m outstanding and ranks first on that asset, as a purchase money security interest would.

Nothing in the business has changed between the two readings. What has changed is that the bank has found a creditor ahead of it. Its credit officer now has to decide whether US$0.49m of effectively unsecured lending is acceptable for this processor, on the strength of its cash flow, and on what terms.

A loan to value ratio measures a single debt against the market value of the property behind it. It suits a residential mortgage or a property investment loan, where one asset secures one debt. On the example, the term loan against the mill site alone is 2.4 ÷ 3.0, or 80%, a figure that says nothing about the overdraft, the bonds, the plant or the prior charge. The loan to security ratio takes the relationship instead: every facility on top, every asset underneath, each at its own ratio. A business can have a comfortable LVR on its main property and a shortfall across the relationship, or the reverse.

The name also turns up in Australian margin lending, where at least one lender calls the loan divided by the market value of the share portfolio its loan to security ratio, and others call the same figure an LVR. It is compared with a ceiling built from each holding's lending value. The two readings agree: a margin loan is inside its ceiling exactly when the loan is no larger than the portfolio's lending value.

DEFINED IN ONE PARAGRAPH → · LOAN TO VALUE RATIO → · WHAT YOUR BANK HOLDS AS SECURITY →

A shortfall does not by itself decline a loan, but it changes the file. The credit paper names it and explains what covers it: cash flow strong enough to carry unsecured lending, a guarantee backed by the owner's own property, or a plan to reduce the limits. A larger shortfall may need a more senior approver, a higher margin or a policy exception. The ratio is recalculated at each annual review, when valuations are refreshed and new facilities added, and whenever the customer asks for a partial release to sell an asset.

The ratio also has a limit of its own. It is a liquidation reading, built on prices the bank expects in a sale it hopes not to run, and it says nothing about whether the business can pay. A loan fully covered by security can still be a bad loan, and the lending values are only as good as the valuation date and the assumptions behind each ratio.

FORCED-SALE VALUE → · THE PANEL VALUER → · HOW BANKS APPROVE BUSINESS LOANS →