Demystified
ave you ever talked to a banker and felt they spoke another language?
Banking and lending terminologies and jargon can seem complex, but you don’t need a translator to understand. Whether you’re seeking financing for the first time, are a seasoned borrower, or just want to enhance your financial literacy, we’re here to help. This article aims to demystify bank speak, breaking down key concepts and definitions to empower you with the knowledge to navigate the intricate terrain of banking and financing confidently. We will cover three main areas of terminology: business financials, loan terms and components, and financial ratios.
Profit and Loss (P&L) or Income Statement: An income statement, also known as a profit and loss statement (P&L), is a financial statement that summarizes a company’s revenues, expenses, and profits (or losses) over a specific period, typically a quarter or a year. Comparing revenues to expenses during the reporting period provides valuable information about a company’s ability to generate profit. The basic formula for an income statement is net operating income (NOI) equals revenues minus expenses (NOI = R – E).
Balance Sheet: A balance sheet is a financial statement that provides a snapshot of a company’s financial position at a specific time. It presents the company’s assets, liabilities, and shareholders’ equity and provides valuable information about its liquidity, solvency, and overall financial health. It is an essential tool for investors, creditors, and other stakeholders to assess the company’s financial position and make informed decisions. The balance sheet follows this fundamental accounting equation: Assets equal liabilities plus shareholders’ equity (A = L + SE).
Shareholders’ Equity: This represents the owners’ claim on the company’s assets after deducting all liabilities. It includes the initial investment by shareholders and any retained earnings (profits that have not been distributed as dividends).
Gross Income Vs. Net Income: Gross income refers to the total income earned by the business before any deductions. It includes all sources of income, in this case for storage, such as rental income, late fee income, administrative fee income, merchandise sales, insurance commission and other earnings, but it does not account for any withheld taxes or deductions. Net income is the final line of the income statement and represents the company’s profit after all expenses, including taxes, are deducted from revenue.
Depreciation: In real estate, depreciation refers to the gradual decrease in the value of a property over time. Depreciation is a non-cash expense that can offset taxable income, reducing the taxes owed by the property owner.
Add-Backs: In commercial lending, an add-back refers to an adjustment made to a company’s financial statements to account for certain expenses that are added back to the net income. These adjustments reflect the true cash flow of the business and provide a more accurate picture of its financial health to lenders or investors. Common add-backs in commercial lending include:
- Non-recurring expenses – These are one-time or irregular expenses that are not expected to occur again, such as one-time repairs, legal settlements, or expenses related to a natural disaster.
- Owner’s compensation – In closely held businesses, the owner’s salary or compensation may be higher or lower than market rates. Lenders may add back any excess or reduce shortfalls to reflect a more accurate picture of the business’ cash flow.
- Non-cash expenses – Expenses that do not require a cash outlay, such as depreciation and amortization, are added back because they reduce net income without affecting cash flow.
- Interest and taxes – In some cases, interest or taxes not reflective of the business’ ongoing operations may be added back to adjust for their impact on net income.
By adding back these expenses, lenders can calculate a more accurate measure of a company’s ability to service debt and make informed lending decisions. However, it’s important for lenders to carefully review and analyze the reasons for the add-backs to ensure they are appropriate and accurately reflect the business’ financial position.
EBITDA: EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is a measure used to evaluate a company’s operating performance by excluding certain non-operating expenses. EBITDA is often used in financial analysis to compare profitability between companies and industries. It provides a clearer picture of the underlying operating performance without the impact of financing decisions, accounting practices, or tax environments.
Equity Injection: Equity injection refers to adding equity, or cash, to a business or project. This injection of funds can come from business owners, investors, or other sources. In commercial lending, lenders often require borrowers to provide an equity injection to reduce the lender’s risk and demonstrate the borrower’s commitment to the project. The equity injection amount is usually expressed as a percentage of the total project cost and can vary depending on the lender’s requirements and the nature of the project.
Loan Term Vs. Loan Amortization: Loan term refers to the period over which a loan agreement is in effect. It is the duration during which the borrower is expected to repay the loan, including the principal amount borrowed and any accrued interest. Loan terms can vary widely, from short-term loans that may be repaid within a few months to long-term loans that span several years or even decades. Loan amortization, on the other hand, refers to gradually paying off a loan over time through regular payments. These payments typically consist of both principal and interest, with the amount applied to each varying over the life of the loan. In an amortizing loan, more early payments go toward interest, while more later payments go toward reducing the principal balance. Amortization schedules outline the specific payment amounts and how they are allocated between principal and interest over the loan term.
Balloon Payment: In commercial lending, a balloon payment refers to a large, lump-sum payment due at the end of a loan term. Unlike typical installment loans, where the borrower makes regular payments of both principal and interest over the loan term, a balloon payment loan structure involves smaller, regular payments for most of the loan term, with the remaining balance (the balloon payment) due at the end. Balloon payments are often used in commercial real estate financing or business loans where the borrower expects to have significant cash flow or assets at the end of the loan term to cover the balloon payment. These loans can offer lower monthly payments during the loan term, but they carry the risk of needing to secure financing or pay off the balloon amount when the loan matures.
Personal Guarantee: A personal guarantee is a legal promise by an individual to repay a debt or fulfill an obligation if the primary borrower or debtor fails to do so. In commercial lending, a personal guarantee is often required from business owners when a business is seeking a loan. The individual agrees to be personally liable for the debt and the business entity by providing a personal guarantee. Lenders use personal guarantees to reduce their risk, especially when lending to small businesses or startups that may have limited assets or track records. If the business is unable to repay the debt, the lender can pursue the guarantor’s personal assets to recover the outstanding amount.
Loan Assumption: Loan assumption refers to the transfer of an existing loan from one borrower to another. In this process, the new borrower (the assuming borrower) takes over the existing loan agreement, including its terms, interest rate, repayment schedule, and remaining balance. The original borrower is typically released from any further obligations related to the loan.
Debt Service Coverage Ratio (DSCR): Debt Service Coverage Ratio (DSCR) is a financial metric that measures a company’s ability to cover its debt obligations with its operating income. It is commonly used by lenders, creditors, and investors to assess the risk of lending to or investing in a company. The formula for calculating DSCR is NOI divided by total debt (DSCR = NOI/TD).
Return on Investment (ROI) – ROI is a financial metric used to evaluate the profitability of an investment relative to its cost. To calculate ROI, you first need to know the net profit, which is the gain or loss generated from the investment and the cost of investment, which is the total amount invested in the project or asset. Then ROI is calculated as net profit divided by cost of investment times 100 (ROI = [NP/COI] x 100). ROI is typically expressed as a percentage. A positive ROI indicates the investment has generated profit, while a negative ROI suggests a loss. ROI is a widely used metric in finance and business to assess investment performance and compare the profitability of different investment opportunities.
Profit Margin: Profit margin is a profitability ratio that measures the percentage of revenue that exceeds the costs associated with generating that revenue. It is calculated by dividing a company’s net income by its revenue (PM = NI/R). A higher profit margin indicates that a company is more profitable, as it can retain a more significant portion of its revenue as profit.
Loan-to-Value (LTV): LTV is a financial term used by lenders to express the ratio of a loan to the value of an asset purchased with the loan. It is commonly used to assess the loan risk and determine the maximum amount that can be borrowed. The formula for calculating LTV is loan amount divided by appraised value of the asset times 100 (LTV = [LA/AVA] x 100). For example, if a borrower wants to buy a storage facility appraised at $2 million and the lender is willing to provide a loan of $1.6 million, the LTV would be (1,600,000/2,000,000) × 100 = 80 percent. This means the loan amount is 80 percent of the appraised value of the facility, and the borrower would need to provide a down payment of 20 percent ($400,000) to meet the lender’s requirements. A lower LTV indicates that the borrower has more equity in the asset, which reduces the lender’s risk. Lenders often have maximum LTV ratios that they are willing to accept based on the type of loan and the borrower’s creditworthiness.
Loan-to-Cost (LTC): LTC is a financial metric used by lenders to evaluate the risk of a loan for a real estate development project. The LTC ratio is calculated by dividing the loan amount by the project’s total cost times 100 (LTC = [LA/PTC] x 100). The project’s total cost includes all costs associated with acquiring and developing the property, such as purchase price, construction costs, renovation costs, and other expenses. The LTC ratio helps lenders assess the amount of risk they are taking by providing a loan for the project. A lower LTC ratio indicates that the borrower has more equity in the project, which can reduce the lender’s risk. Lenders typically have maximum LTC ratios that they are willing to accept based on the type of project and the borrower’s creditworthiness.
Debt-to-Income (DTI) Ratio: The DTI ratio is a financial metric that compares a person’s monthly debt payments to their gross monthly income. Lenders use it to assess an individual’s ability to manage monthly payments and repay debts. The DTI ratio is calculated by dividing the total monthly debt payments by the gross monthly income and multiplying by 100 to express the result as a percentage (DTI = [MDP/GMI] x 100). For example, if a person has total monthly debt payments of $2,000 and a gross monthly income of $6,000, their DTI ratio would be (2,000/6,000) × 100 = 33.33 percent. A lower DTI ratio indicates that a person has a lower level of debt relative to their income, which lenders generally view positively. Lenders often use DTI ratios as part of their loan approval process, with lower ratios indicating lower risk for the lender. The acceptable DTI ratio can vary depending on the type of loan and the lender’s requirements.
Many financial terms may sound complicated, but they just describe things like revenue, loans, and interest rates. By demystifying complex terminologies related to business financials, loan terms, and financial ratios, you can confidently engage with bankers and lenders and make intelligent financial choices. Whether you’re a seasoned borrower or a first-time seeker of financing, this knowledge empowers you to make informed decisions and manage your financial affairs effectively. So next time you converse with a banker, rest assured that you’re speaking the same language!