The next link in the chain to reviewing a transaction is a consideration of Capital.
What good does it do a financial institution to finance your transaction if you are unable to pay for it?
A scenario like this harms the financial institution, harms your credit, and can be devastating financially for both parties.
You would think that capital is the same as cash flow, even though they are similar, they are not the same.
Capital can sometimes be used to generate cash flow and in this sense is good for the bank in the event you default but it is secondary.When it comes to capital any bank or financial institution is looking to ensure that the owner of the company, or borrowed themselves, has sufficient equity in the company or in their personal investments.
Capital is important for two main reasons.
- First, having sufficient equity provides a cushion to stand any change in the company's ability to generate cash flow. For example, if the company were to be unprofitable for any length of time, this equity could be liquidated, by either the borrower or the financial institution, to repay any debt (or default).
- Secondly, the financial institution is ensuring that the owner (or borrower) is sufficiently invested in the company (or themselves) and if things were to go wrong that there would be sufficient motivation to stand by the company or your personal investments.
This measurement is called a “debt to equity ratio”.
A financial institution will compare your total net worth. In relation to your outstanding debts, including the new loan or lease amount in order to measure the borrowers, or companies, total debt.
If the new transaction raises your company’s debt-to-equity ratio beyond the financial institutions risk tolerance level, the transaction will usually be declined or further collateralized.
In short, the financial institution wants to make sure that you have skin in the game and that you have the ability to stand behind your debt obligations.
I hope you find this helpful,
John
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