Ratios used by banks and other lending institutions in credit analysis
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Written byCFI Team
What are Lending Ratios?
Lending ratios, or qualifying ratios, are ratios used by banks and other lending institutions in credit analysis. Financial institutions assign a credit score to borrowers after performing due diligence, which involves a comprehensive background check of the borrower and his financial history.
Lending ratios are extensively used in the underwriting approval processes for loans.Lending ratio usage varies across lenders. They apply different ratios in credit analysis, and the choice depends on the borrower’s goals and the projects where they plan to deploy capital.
The ratios help to define whether individual or institutional borrowers will be able to fulfill financial obligations after obtaining a loan. The credit analysis process consists of qualitative and quantitative methods. Lending ratios are an integral part of quantitative analysis.
Summary
- Lending ratios exist to conduct credit and financial analysis of potential borrowers before loan origination.
- They include the debt-to-income ratio, the housing expense ratio, and the loan-to-value ratio.
- Lending ratio usage varies across lenders.
Types of Lending Ratios
1. Debt-to-Income Ratio
The debt-to-income ratio (DTI) is a lending ratio that represents a personal finance measure, comparing an individual’s debt repayments to his or her gross income on a monthly basis. Gross income is simply a monthly paycheck before one pays off the costs, such as taxes, interest expense, etc.
In other words, the debt-to-income ratio is a percentage of gross income that goes to debt service (paying off debt).The ratio is calculated by taking the total monthly debt payments divided by gross monthly income.
Debt-to-Income Ratio = Total Monthly Debt Payments / Gross Monthly Income
The DTI ratio is a very popular metric for mortgage lenders that evaluate an individual’s ability to manage monthly debt payments for a property that was bought on debt.
Interpreting the DTI Ratio
After computing the DTI ratio, lenders draw conclusions about the financial situation of an individual based on his or her gross monthly income and debt expenses.
A low debt-to-income ratio indicates a relatively good balance between income and debt. If, for example, a potential borrower’s DTI ratio is equal to 14%, it means that 14% of their monthly gross income goes to debt repayments (debt service).
On the other hand, if the DTI ratio is relatively high, say, 43%, it signals to a lender that an individual holds a significant amount of debt in relation to the money earned each month. By the way, 43% is the highest DTI ratio a borrower can get achieve and still be eligible to secure a loan.
So, the lower the debt-to-income ratio, the more likely a borrower will not encounter any problems with paying off the debt. As a result, banks and other credit providers want to see low DTI ratios for borrowers before originating loans. Typically, a DTI ratio lower than 36% is preferred by lenders.
2. Housing Expense Ratio
The housing expense ratio is a lending ratio that compares housing expenses to a pre-tax income. The ratio is often used in conjunction with the debt-to-income ratio when assessing the credit profile of a potential borrower. It is also used in determining the maximum level of credit to be issued to a borrower.
The housing expense ratio requires the disclosure of a borrower’s pre-tax income, which is an essential factor for both the debt-to-income ratio and the housing expense ratio.
To calculate the housing expense ratio, a lender will sum up all the housing expense obligations of a borrower. They include the operating expenses, such as future mortgage principal and interest expenses, property insurance costs and taxes, housing association fees, etc.After summing everything up, the sum is divided by the borrower’s pre-tax income to arrive at the housing expense ratio.
Housing Expense Ratio = Housing Expenses / Pre-Tax Income
Importantly, the housing expense ratio can be calculated using both monthly and annual payments.
The threshold for the housing expense ratio set by lenders for mortgage loan approvals is typically equal to 28%.
3. Loan-to-Value Ratio
The Loan-to-Value ratio (LTV) is a lending ratio used by financial institutions in assessing the lending risk before approving a mortgage for property purchase.
The loan-to-value ratio represents a certain portion of an asset’s value (e.g., a house) to be issued as debt to a borrower. The portion of the financing is defined by the lender after due diligence and is based on the borrower’s credit score.
For example, if an individual plans to buy a house appraised at $100,000 and intends to obtain financing to purchase it, he or she will be first assigned a credit score by a bank. The credit assessment will help define the maximum amount of the mortgage to be issued for house acquisition.
The formula for the LTV ratio is as follows:
Loan-to-Value Ratio = Amount of Mortgage / Property Value
Let’s say the bank decides to lend $70,000 to the borrower. According to the above formula, it will be a 70% LTV ($70,000 / $100,000). So, the remaining 30% of the property value ($30,000) would need to be paid out of the borrower’s pocket.
Interpreting the LTV Ratio
The higher the loan-to-value ratio, the higher the risk. The higher the risk, the higher the return (compensation) a lender will claim in return for the loan issuance. So, borrowers with higher LTV ratios will pay more interest compared to those with a lower LTV ratio.
4. Working Capital Ratio
The working capital ratio, also known as current ratio, indicates how much current assets a company owns relative to its current liabilities. The ratio shows how easily the business can meet its short-term obligations that are due within a year. So, the working capital ratio is equal to current assets divided by current liabilities.
Working Capital Ratio = Current Assets / Current Liabilities
The main accounts that are going to be included here on the current asset side are:
- Cash
- Accounts Receivable
- Inventory
On the current liability side, the accounts are as follows:
- Accounts payable
- Short-term debt
- Current portion of long-term debt
Interpreting the Working Capital Ratio
If the working capital ratio is greater than one, the company obviously holds more current assets than current liabilities, and thus it can meet all of its current obligations within the year using just its existing assets.
5. Debt-to-Equity Ratio
The debt-to-equity ratio highlights a company’s capital structure. The formula is:
Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity
Total liabilities include short-term and long-term debt, plus any other liabilities. One can also use a more conservative formula of:
Total Liabilities-to-Tangible Net Worth Ratio =
Total Liabilities / (Shareholders’ Equity – Intangible Assets)
Interpreting the Debt-to-Equity Ratio
A high debt-to-equity ratio commonly indicates an aggressive growth strategy. If the extra debt does not lead to an increase in revenues, it can result in insolvency.
6. Debt Service Coverage Ratio
Debt service coverage ratio, or DSCR, measures the ability of a company to use its operating income to repay all its debt obligations. In other words, the DSCR indicates how easily a company can meet its debt obligations using its operating income.
The different ways to calculate the DSCR are as follows:
DSCR = EBITDA / Interest + Principal
DSCR = (EBITDA – Capital Expenditure) / Interest + Principal
DSCR = EBIT / Interest + Principal
Interpreting the Debt Service Coverage Ratio
A lower ratio shows an increased probability of default. If the DSCR is less than 1, it suggests the company is unable to service its debt obligations with operating income alone. It currently makes principal and interest payments that are greater than its operating profit or its EBITDA minus CAPEX, or whatever the numerator is in the formula.
If the DSCR is more than 2, it indicates a good sign generally across the industries.
For example, in the coal mining industry, the DSCR needs to be extremely high – about seven times on average. The reason it is so high is that coal mining is very cyclical, and it requires a lot of capital expenditures. Lenders need to be very careful while lending money to coal mining companies.
On the contrary, the service industry only requires a DSCR of three and a half times. The service industry is very light on capital expenditures, and it is not very cyclical.
Related Readings
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst.To keep advancing your career, the additional CFI resources below will be useful:
