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Commercial LOC, what to count for debt?


Your question:

When my borrower has a commercial line of credit, I am confused as to what interest we can add back and what interest we need to subtract and WHY?

Linda says:

Most commercial lenders add back interest and put the annual debt service on a debt list for calculation of the debt coverage ratio. Consumer or mortgage lenders, or even a commercial lender calculating excess business cashflow available to (or shortfall needed from) an owner/guarantor, will add back interest and subtract the debt from business cashflow.

Either way, we need to figure out the debt amount for the year. For term debt, that is an easy call; monthly payments times 12. But what if a business has access to a $750,000 commercial line of credit?

There are three common choices:

1) On a historical basis, count the actual interest paid last year. If they only borrowed a portion of the line, the interest may be fairly low.

2) To be more conservative, though, most lenders want to know that the borrower can cover the interest expense if they advance the entire $750,000 line of credit. That is easy to calculate if you know the full amount of the available line and the interest rate.

3) Even more conservative…what if they get to the end of the year and cannot pay the line of credit back as agreed? Depending on the circumstances, some business lenders might make a choice to ‘roll’ the balance over. (They are not likely to do that more than once and not even once if the business is stressed.)

The other option is to term the debt out, typically over three or five years. If the line of credit is fairly new (so you do not know if the customer is likely to pay as agreed) or the customer is having trouble, consider calculating the payment that would be needed to term the $750,000 out over the three or five years and count that debt against them.

You are right; it can seem confusing if the only interest is interest on their line of credit. If you are doing net cashflow after debt (instead of calculating Cashflow Available to Pay Debt), you add it back… then turn around and subtract it.

The key to understanding what we are doing is this: The add back is an elimination step…get to cashflow before the debt payments. If it turns out the only debt payment is interest on a commercial line of credit, you will indeed be subtracting it back out if you are calculating excess business cashflow available to (or shortfall needed from) the owner/guarantor.

For all of those reasons, most cashflow worksheets including mine have you add back the full interest and make a separate debt entry. In the rare case that the only interest they have is line-of-credit interest and they had the line fully in use all year, those two numbers will be the same.

About the Author
Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis. She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.