Many small business loans are secured by collateral, such as property or equipment, to provide security to a lender in case a borrower is unable to repay. The collateral coverage ratio (CCR) is used by lenders to set maximum loan limits on a borrower. It compares the collateral’s discounted value to the amount borrowed. Most lenders use 1.0 as a minimum acceptable CCR but will increase this ratio based on borrower risk and their credit.
Collateral Coverage Ratio Formula
Calculating the collateral coverage ratio is relatively simple:
Collateral Coverage Ratio =
(Discounted Collateral Value) / (Total Loan Amount)
Collateral Coverage Ratio Example
Now that you know the formula, let’s discuss each component of the collateral coverage ratio in detail. This will help you calculate your discounted collateral value, total loan amount as well as your overall collateral coverage ratio.
Discounted Collateral Value
Collateral value is the estimated fair market value (FMV) or appraised value of an asset used to secure a loan. However, when a lender determines a maximum borrowing limit, they’ll typically discount the collateral the loan is securing. This builds in the potential for a decline in value through normal use, change in property values, and collection costs in case a borrower defaults.
Lenders normally require that a loan can’t be more than the discounted value of the underlying collateral. These discounted rates will vary based on the potential for a decline in value. This explains why real estate often has a discounted collateral value of 80% while furniture, fixtures, and equipment (FF&E) might have a discounted collateral value that ranges between 30% and 70%.
For example, if you need $20,000 in short-term capital, you might be able to take out a working capital loan and intend to collateralize it with either used equipment or office furniture. However, a lender might discount these assets differently, limiting your financing options. If you have $50,000 of used equipment that a lender discounts by 50% and $25,000 of office furniture that a lender discounts by 70%, the discounted collateral values would be:
Used Equipment: ($50,000) x (50%) = $25,000
Office Furniture: ($50,000) x (30%) = $15,000
Total Loan Amount
Total loan amount represents your total current principal loan balance, excluding interest payments. For example, if you take out a loan for $100,000 and you pay off $10,000 in principal and $2,000 in interest in the first year, your total loan amount at the end of the year is $90,000.
Once you know your discounted collateral value and your total loan amount, you can calculate your collateral coverage ratio. Based on the example above, the discounted collateral value of your used equipment is $25,000 and your office furniture is $15,000. If a lender requires a ratio of at least 1.0, the only option in this instance would be to collateralize against the used equipment:
Used Equipment: ($25,000) / ($20,000) = 1.25
Office Furniture: ($15,000) / ($20,000) = 0.75
If you need $30,000 instead of $20,000, the office furniture can be included as collateral and blended in as part of the lender’s overall lien. However, the combined ratio still cannot be below the lender’s minimum.
Used Equipment: ($25,000) / ($30,000) = 0.83
Office Furniture: ($15,000) / ($30,000) = 0.50
Total Assets: ($40,000) / ($30,000) = 1.33
Why is the Collateral Coverage Ratio Important?
The collateral coverage ratio is important because lenders and creditors use it to determine maximum loan amounts and minimum required asset collateral. This ratio reduces their risk by ensuring there’s enough collateral to cover the loan in case of default. The higher the ratio the less risk for lenders.
Most lenders have a minimum CCR of 1.0 for prime borrowers and will increase the CCR requirement depending on a borrower’s credit, the industry the borrower is in, and a borrower’s overall debt exposure. A borrower in an industry with a history of higher loan defaults or a borrower with a marginal credit score may warrant a CCR closer to 1.5 or 1.6. Borrowers with ratios below the bank’s guideline will either need additional assets to secure a loan or apply for a Small Business Administration (SBA) loan that features the SBA’s guarantee in case of borrower default.
Increasing Your Collateral Coverage Ratio
Collateral helps your chances of getting approved for a loan because it reduces lender risk in case of default as you have pledged assets that can help repay the defaulted loan. If your collateral coverage ratio is low, however, it might be difficult for you to get financed for the amount you need.
The following are ways to increase your collateral coverage ratio:
- Pledge higher value assets as collateral: If you’re looking for $30,000 in financing and have a purchase order for $100,000 and outstanding invoices totaling $50,000 as available assets, purchase order financing may be an option to consider due to its higher value.
- Pledge assets with lower discount rates: Talk to your lender and find out how much they’ll discount your assets. Use the assets that have a lower discount rate, such as real estate, to help increase your coverage ratio.
- Collateralize multiple assets: We touched on this earlier in the article. Many lenders will place a blanket lien on your assets and blend the discounted values to help boost your coverage ratio as well as provide you with a larger sum of available funds to borrow.
The CCR calculates the percentage of your loan secured by a discounted asset. That discount rate varies by the type of asset that’s being collateralized, with real estate getting the lowest discount rate. Lenders typically want a CCR of at least 1.0 to give them a buffer in case of default. The higher a CCR is, the lower the risk to the lender and the more likely your loan will be approved.