Commercial lenders assess whether a business generates enough cash to meet its debt payments, expressed as a coverage ratio. The construction of that ratio explains most credit decisions.
The ratio compares cash flow to obligations
The numerator approximates cash available to service debt, typically starting from operating earnings and adding back non-cash charges such as depreciation.
The denominator is total required payments over the period, including principal as well as interest, and covering all obligations rather than only the new loan.
A ratio of exactly one means every available dollar goes to debt service with nothing left for anything else, which is why lenders require a margin above it.
The required cushion reflects perceived volatility
A business with stable contracted revenue can be lent to at a thinner cushion than one whose income swings with commodity prices, weather or discretionary consumer spending.
The cushion is protection against forecast error, not against normal operating expenses, which are already deducted before the calculation.
Different lenders and different asset types carry different conventional minimums, and those conventions tighten when credit conditions deteriorate.
Adjustments are where disagreement happens
Borrowers add back owner compensation above market, one-time expenses and discretionary items to present a higher figure.
Lenders accept some of these and reject others, and a normalization the borrower considers obvious may be treated as recurring by the credit analyst.
Documenting each adjustment with evidence, rather than presenting an adjusted number without support, is what determines whether it survives review.
Distributions and taxes come before debt service in practice
Owners of pass-through entities must fund tax liabilities personally, so distributions to cover them are not discretionary regardless of how they appear in the accounts.
Lenders working with closely held businesses generally deduct a reasonable owner salary and required distributions before calculating coverage.
Ignoring this produces a ratio that looks acceptable while the business cannot actually make the payments after its owners have met obligations.
The ratio usually appears as a covenant too
Coverage is used both to approve the loan and to monitor it, with a minimum tested quarterly or annually for the life of the facility.
A breach can trigger default provisions even when payments have been made on time, which is why the tested definition in the agreement matters.
Definitions vary between agreements and adjustments are negotiable, so the precise calculation belongs in discussion with the lender and the borrower's accountant before signing.