Underwriting 101 - Credit Analysis
Personal credit of the principals (any proprietors, partners and stockholders owning 20% or more of voting stock and all guarantors) and the business credit of the operating company will be evaluated.
Personal Credit: A lender will also obtain personal credit reports to see how much personal debt the primary owner(s) of the business is/are carrying and their payment history. With the personal credit report, we determine if business owners are taking adequate salaries to cover their personal debt obligations. If an owner is not taking an adequate salary, the cash flow of the business might be reduced to compensate. If an owner is taking more than an adequate salary, a positive adjustment might be made to the company's cash flow. A personal debt calculation is determined for all principals by comparing the amount of annual debt payments they must pay to the amount of annual income they earn.
Personal Debt Coverage Ratio (PDCR) = Annual Personal Debt/Annual Personal Income.
A more precise measure of how personal debt affects your lending decision can be found by measuring excess owner compensation. Excess owner compensation is calculated by determining the total annual personal expenses for the principals. Then, assuming a 40% to 45% debt-to-income ratio, the borrowers’ total expenses are divided by 40% or 45%. Finally, the quotient (Total Expenses/40% or 45%) is subtracted from the principals’ combined wages, tips, and salaries. In many cases, the expenses are less than the income (when the 40% to 45% debt-to-income ratio is used) and therefore a lender may "add back" a positive cash value to appropriately depict the true repayment ability. In cases where the expenses exceed income, an owner "draw" is "added-back" resulting in a subtraction from the cash available figure and thereby reducing the DSC.
Personal credit reports also give personal credit scores ranging up to a maximum of 900. The average borrower typically has a credit score of around 715 in commercial lending. Anything lower than a 640 score will need some explanations and if you are below 600, you will probably need to focus on improving your score before purchasing or at least provide very good written explanations.
Business Credit: Lenders will also secure an overview of the operating company's credit history from a business credit report and do a similar analysis relating to the business' historical repayments of debt, amounts of debt, and so forth.