Serviceability: a Worked Example

A term loan is repaid over years from money the business has not yet earned. Security reduces the loss if that money does not appear, but a lender holding good security over a business that cannot pay still has a problem file. Serviceability is therefore read first, and read on the whole debt load: every lender's interest and scheduled principal, plus lease payments if the agreement or the lender's policy treats them that way.

The cash that counts is what remains after the business has paid its tax and kept its equipment running. Profit is not cash: stock and receivables can absorb money the income statement shows as earned, and owners' drawings can take out more. A lender adjusts for each before calling the figure available.

Where principal is scheduled, debt service cover is the natural measure. Where the loan is interest-only, or a revolving line with no repayment profile, interest cover is used because there is no scheduled principal to count. The rate used in the higher-rate test is generally the lender's own choice on a company's loan. Regulation sets a more specific frame for home loans, covered under the serviceability buffer; in business lending, Australian prudential guidance asks banks to review and challenge cash flow projections without prescribing a rate.

A maker of insulated glass units for builders, constructed for this page like every figure in it, asks for a US$8.0m term loan repaid at US$1.0m a year, at a floating rate of 7 per cent. It also has an overdraft limit of US$1.5m. Cash available over the last three years was US$2.4m, US$1.6m and US$2.6m. The two-point rate rise is the example's choice, not a market norm.

On the average, the loan looks comfortable. In the weakest year it barely covers at the actual rate and falls short at the higher one, so the bank learns that a repeat of that year combined with higher rates would have the business drawing on its overdraft to meet the term loan. Interest cover of more than four times tells it almost nothing here, because a principal repayment of US$1.0m is in the service and not in that ratio. The forecast then needs reading by month, since builders slow in the southern winter.

The forecast services comfortably across the year and still runs out of facility in June. The cure here costs almost nothing: the same US$1.0m of principal is simply placed in the months that can pay it. A larger overdraft would also work, at the cost of a limit the business needs for only a few weeks of the year. Which the lender prefers is a judgement on the file.

Serviceability is the question; the ratios are ways of answering it. A loan-to-value ratio answers a different question, what the lender recovers if the answer turns out badly. Leverage says how much debt a business carries relative to its earnings without saying when it falls due, so two businesses at the same leverage can have very different service burdens depending on term and amortisation.

An owner-run business adds a further layer. A lender may look through the company to the owners' other commitments, because salaries and dividends that fund a personal mortgage are not freely available to the bank. That is global cash flow. The downside case goes wider than the rate test, changing volumes, margins or the timing of a contract as well.

DEFINED IN ONE PARAGRAPH → · HOW BANKS TEST BORROWER FORECASTS → · THE TERM LOAN →

Serviceability often sets the size of the loan before any other test. A lender can work backwards from the cash available and a cover its policy requires to the debt service the business can carry, and from there, through the rate and term, to a loan amount. A borrower who is asking for more than that figure has three levers: a longer term, an interest-only period, or more equity. Each can be right, and each has a cost the lender will read.

It also reappears after drawdown. A cover covenant in the facility agreement turns the serviceability test into a recurring obligation, reported at each test date, and a downward trend usually becomes visible there first. A lender reads a cover that has fallen for three quarters as a repayment question arriving early, and is better placed to act on it while headroom is still positive.