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This calculator will help you calculate your collateral coverage ratio. In the banking industry, a collateral coverage ratio is used to determine how much of a bank’s assets are backed by equity and cash reserves. This ratio was developed as part of Basel II in order to measure banks’ capital requirements for liquidity risk management purposes. It can be calculated by dividing total loans/deposits (total liabilities) into tier 1 capital
The “collateral coverage meaning” is a ratio that measures the amount of collateral that an organization has compared to its total debt. This ratio helps lenders determine how much risk they are taking on when lending money.
Many small company loans are secured by collateral, such as real estate or equipment, to give security to the lender in the event that the borrower defaults. Lenders utilize the collateral coverage ratio (CCR) to determine a borrower’s maximum lending limit. It compares the discounted value of the collateral to the amount borrowed. Most lenders set a minimum acceptable CCR of 1.0, however they may raise it depending on the risk and credit of the borrower.
Formula for Collateral Coverage Ratio
It’s easy to figure out the collateral coverage ratio:
(Collateral Value Discounted) / (Collateral Coverage Ratio) (Amount of the Loan)
Example of a Collateral Coverage Ratio
Let’s go down each component of the collateral coverage ratio now that you know the formula. This will assist you in determining your Collateral Value Discounted, Amount of the Loan, and overall collateral coverage ratio.
Collateral Value Discounted
The estimated fair market value (FMV) or evaluated worth of an item used to secure a loan is known as collateral value. When a lender sets a maximum borrowing limit, however, the collateral used to secure the loan is usually discounted. This accounts for the possibility of a loss of value due to regular usage, changes in property prices, and collection expenses in the event that 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 Collateral Value Discounted of 80% while furniture, fixtures, and equipment (FF&E) might have a Collateral Value Discounted 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 Collateral Value Discounteds would be:
($50,000) x 50% = $25,000 in used equipment Furniture for the office: $50,000 x 30% = $15,000
Amount of the Loan
Amount of the Loan 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 Amount of the Loan at the end of the year is $90,000.
Once you know your Collateral Value Discounted and your Amount of the Loan, you can calculate your collateral coverage ratio. Based on the example above, the Collateral Value Discounted 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:
Office Furniture: ($15,000) / ($20,000) = 0.75 Used Equipment: ($25,000) / ($20,000) = 1.25
If you require $30,000 instead of $20,000, the office furniture might be used as collateral and included into the total lien of the lender. The aggregate ratio, however, cannot go below the lender’s minimum.
($25,000) / ($30,000) = 0.83 Used Equipment Furniture for the office: $15,000 / $30,000 = 0.50 ($40,000) / ($30,000) = 1.33 Total Assets
What is the significance of the Collateral Coverage Ratio?
The collateral coverage ratio is significant because it is used by lenders and creditors to calculate maximum loan amounts and minimum asset collateral requirements. By guaranteeing that there is adequate collateral to pay the loan in the event of failure, this ratio lowers their risk. For lenders, the larger the ratio, the lower the risk.
Most lenders set a minimum CCR of 1.0 for prime borrowers and will raise it based on the borrower’s credit, industry, and total debt exposure. A CCR of 1.5 or 1.6 may be appropriate for a borrower in an industry with a history of increased loan defaults or a borrower with a low credit score. Borrowers with ratios below the bank’s guidelines will either require more assets to receive a loan or will need to qualify for a Small Business Administration (SBA) loan, which includes the SBA’s guarantee in the event of failure.
Collateral Coverage Ratio Enhancement
Collateral improves your chances of securing a loan since it decreases lender risk in the event of failure by pledging assets that may be used to repay the defaulted debt. However, if your collateral coverage ratio is poor, you may find it difficult to get financing for the amount you want.
There are a few things you can do to improve your collateral coverage ratio:
- Buy order financing may be an alternative to examine because of its greater value. For example, if you need $30,000 in financing and have a $100,000 purchase order and $50,000 in outstanding invoices as accessible assets, purchase order financing may be an option to consider.
- Pledge assets with lower discount rates: Talk to your lender about how much your assets will be discounted. To assist boost your coverage ratio, choose assets with a lower discount rate, such as real estate.
- Collateralize numerous assets: As mentioned previously in the text, this is a good idea. Many lenders may put a blanket lien on your assets and combine the discounted values to increase your coverage ratio and give you a bigger amount of money to borrow.
Conclusion
The CCR determines how much of your loan is backed by a discounted asset. The discount rate varies depending on the kind of collateralized asset, with real estate receiving the lowest discount rate. Lenders want a CCR of at least 1.0 to provide a cushion in the event of default. The higher the CCR, the less risky your loan is to the lender, and the more probable it is to be accepted.
The “loan-to collateral ratio formula” is a tool used to calculate the collateral coverage ratio. This ratio is also known as the loan-to-collateral ratio, and it can be used by lenders when evaluating whether or not to give a loan.
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