How Do Lenders Evaluate Risk in Acquisition Lending?

Updated: September 30, 2024

How Lenders Evaluate Risks for Acquisitions

Here's a quick primer on how senior lenders think about risk with a loan request where an individual is using debt to finance an acquisition.

Banks will lend if they believe:

     a. They will earn a sufficient risk-adjusted return, and

      b. Their expected loss is low enough

We'll ignore (a) for now, but in simple terms, it implies that a riskier deal will lead to higher costs for the borrower. Regarding (b), the lender does not actually expect to lose money, but they will calculate the following:

Expected Loss = Likelihood of Default x Loss if Default Occurs

This outcome represents the percentage of the loan value that the lender expects to lose on a deal over the course of the loan. This is the same as public bond ratings by companies like Moody's.

- Loss if Default Occurs is determined by the quality of the collateral used to secure the loan, meaning companies with hard assets and guarantors with strong net worth will be more likely to secure a loan on favourable terms.

- Likelihood of Default is typically the primary driver of the yes/no lending decision. For most lenders, the rating is generated using historical financial data for the company adjusted for new debt, in combination with qualitative factors about the business.

The weighting of those data points varies greatly between industries, but in general, the financial ratios drive a large majority of the overall rating (80-90%). Within the financial ratio section, cash flow and leverage are the most important factors, followed by liquidity.

Knowing what the implied cash flow, leverage and liquidity ratios will be following your proposed acquisition will help you get a sense of the likelihood that a lender will support.

How You Can Improve Your Chances of Reducing Risk and Securing a Loan With Lenders

Checking the following ratios gives you a much higher chance of securing a loan.

Debt Service Coverage Ratio

The Debt Service Coverage Ratio (DSCR) measures a company's ability to service its debt, assessing whether the company can cover its debt payments (both interest and principal) with its operating income. A debt service coverage ratio above 1 shows that a company generates enough income to cover its debt payments.

However, most lenders are looking for that ratio to be 1.3 or more.

Total Debt to EBITDA

This financial ratio also measures a company's ability to pay off debt, but compares total debt to its earnings before interest, taxes, depreciation, and amortization (EBITDA). Total Debt to EBITDA indicates how many years it would take for a company to repay its total debt if EBITDA remained consistent and all its earnings were used to pay off debt. Generally speaking, the lower the ratio, the better.

For it to pass a lender's criteria, this ratio should be below 3.5 meaning 3.5 years to pay off its debt using current EBITDA.

Total Debt to Equity

Total Debt to Equity measures the relative proportion of a company's debt to its shareholder's equity. This shows how much debt the company uses to finance its operations compared to the value of shareholders' interests. A higher ratio suggests that the company relies on debt more to service its operations which is risky if the company faces financial problems.

A ratio below 5 is ideal for lenders to consider.

Current Ratio

The Current Ratio measures a company's ability to meet its short-term obligations within a year using its short-term assets. This ratio evaluates a company's health and its ability to pay off its debts in the short-term. A current ratio of 1 means that it has just enough assets to cover it's liabilities. This means that the higher the number, the better. Anything lower than 1 means that the company may have some problems covering its obligations in the short-term.

Lenders want to see a ratio that is 1.2 or higher before considering lending.

Evaluating Risks in Acquisitions

If these ratios are in line, and lenders believe in your plan to continue driving profitable growth within the company, you'll likely soon be moving to negotiating terms.

Increase Your Chance of Acquiring a Business

Do you need help getting financing to acquire a business?

Buyers using Acquirewell+ have a 70% success rate in purchasing a business, compared to just 30% when going solo. Our advisors at Village Wellth can help you secure favourable lending terms and work with multiple banks on your behalf.

Find out how Acquirewell+ can help you secure your business acquisition.