You can borrow virtually any amount from a bank, as long as you meet the banks’ lending and regulatory criteria. These are the two general limitations on the amount you can borrow from a bank.

1. Regulatory limitation

The regulation limits a national bank’s total outstanding loans and extensions of credit to a borrower to 15% of the bank’s capital and surplus, plus an additional 10% of the bank’s capital and surplus, if the amount exceeds the limit. The bank’s general 15 percent is fully secured by a readily tradable collateral. In simple terms, a bank cannot lend more than 25% of its capital to a borrower. Different banks have their own internal limitation policies that do not exceed the 25% limit set by regulators.

The other limitations are related to the type of credit. These also differ from bank to bank. For example:

2. Loan Criteria (Loan Policy)

This can also be categorized into product and credit limitations, as explained below:

• Product limitation

Banks have their own internal credit policies that describe internal lending limits by loan type based on the bank’s appetite to reserve that asset for a particular period. A bank may prefer to keep its portfolio within established limits, for example, 50% real estate mortgages; real estate construction 20%; term loans 15%; working capital 15%. Once a limit on a certain class of product reaches its maximum, there will be no further lending of that particular loan without Board approval.

• Credit limitations

Lenders use various lending tools to determine loan limits. These tools can be used on their own or as a combination of more than two. Some of the tools are discussed below.

leverage

If a borrower’s leverage or debt-to-equity ratio exceeds certain limits set out in a bank’s lending policy, the bank will be reluctant to lend. When the total debt on an entity’s balance sheet exceeds its capital base, the balance sheet is said to be leveraged. For example, if an entity has $20 million in total debt and $40 million in equity, it has a debt-to-equity or leverage ratio of 1:0.5 ($20 million/$40 million). This is an indicator of the extent to which an entity is dependent on debt financing. Banks set individual upper internal limits on debt to equity ratios, typically 3:1 with no more than one-third of the debt long-term.

Cash Flow

A company can be profitable but have little money. Cash flow is the oil engine of a business. A business that doesn’t collect its accounts receivable on time, or that carries a large and perhaps obsolete inventory, could easily go out of business. This is known as cash conversion cycle management. The cash conversion cycle measures the length of time each dollar input is tied up in the production and sales process before it is converted to cash. The three components of working capital that make up the cycle are accounts receivable, inventory, and accounts payable.

Cash conversion cycle = accounts receivable + inventory – accounts payable

Debt Service Coverage Ratio (DSCR)

Banks pay special interest on a borrower’s ability to pay principal and interest. After all, they are in the business of lending money in return (interest). Banks typically require a debt service coverage ratio of at least 1.20. In simple terms, that means if you borrow $100, your debt service coverage ratio must be at least $120. This ratio will also determine the level of debt a borrower can take on.

Refund Source

A payment source may also limit the amount of money that can be borrowed. For example, if the source of repayment is rental income from a property that has a history of high vacancy, a bank may heavily discount expected rental income, thus limiting the amounts that can be borrowed.

Collateral

While in theory many lenders say collateral is the last criteria they consider when reviewing a loan application, in practice, however, collateral comes first. Lenders measure collateral adequacy using a ratio known as loan-to-value (LTV). The loan-to-value ratio of 80% is considered satisfactory. This means that if your collateral is worth $100, you are eligible to borrow a maximum of $80, other things being equal. The quality of the guarantee plays an important role in deciding the discount factor of a guarantee. For example, the discount factor for real estate is less than that for accounts receivable or inventory.

Other loan criteria

A lender concerned with management experience may reduce the loan request in order to minimize risk. Other risks, such as industry, business, and political risks, can influence a lender’s decision to determine the amount past due.

Prepared by:

Frank Kigondu

main subscriber

http://www.loansunderwriting.com