Loan-to-value ratio
The loan-to-value ratio (LTV) determines the maximum amount of a secured loan based on the market value of the asset pledged as collateral. (For a secured loan, the borrower gives the lender claim to an asset in case he or she can’t pay back the loan.)
The market value of an asset is the typical price that would be paid for the asset on the open market between two unrelated parties. If the asset offered as collateral is relatively easy to convert into cash (i.e., highly liquid), you’ll be more likely to be able to obtain a bigger loan.
François-Xavier Lemay, Manager, Business Centre, BDC, explains how to calculate this ratio and how it’s used by banks and other financial institutions.
What is the formula for calculating the loan-to value ratio?
Secured loan amount
Market value of collateral
To calculate the loan-to-value ratio, divide the amount of the loan being requested by the market value of the asset that the business gives as collateral to the lender.
The market value may be lowered if the asset has low liquidity, that is, if it could take time before the financial institution can have the money on hand. This length of time often comes with associated costs, such as hiring a real estate broker to look at a building. The institution factors that in by reducing the market value.
The market value given to an asset varies depending on the context and the financial institution.
Sample calculation of loan-to-value ratio
Let’s say a business wants to purchase a building with a market value of $1 million. This amount may be determined by a certified appraiser, or by the two parties who agree to carry out the sale of the building. If the company invests $200,000 in the project and applies for a loan of $800,000, the loan-to-value ratio is 80%.
Secured loan amount: $800,000
Market value of collateral: $1,000,000
“The loan would represent 80% of the market value of the asset,” explained Lemay.
How is the loan-to-value ratio used by financial institutions?
The loan-to-value ratio is one of the things that banks look at before they agree to a loan. “Obviously, it’s reassuring for lenders to see that the value of the assets meets or exceeds the value of the loan,” said Lemay.
But this ratio isn’t the only factor that is considered by financial institutions. They’ll also look at the company’s profitability, cash flows, industry trends and equity. “In order to be able to pay back its loan, the company has to turn a profit,” said Lemay. They won’t be able to do that if they’re losing money.”
What is a good and a bad loan-to-value ratio?
Financial institutions don’t use the same loan-to-value ratio for all asset types. Why? Because of different asset liquidity levels. Banks will lend at a higher ratio if it’s easy for them to convert the asset into cash.
This chart gives an idea of how the loan-to-value ratio can vary from one asset type to another.
| Asset type | Liquidity | Market value | Loan-to-value ratio | Maximum loan amount |
| Marketable securities | High | $100,000 | 90% | $90,000 |
| Accounts receivable | $100,000 | 75% | $75,000 | |
| Residential real estate | $100,000 | 80% | $80,000 | |
| Commercial and industrial real estate | $100,000 | 65% to 100% | $65,000 to $100,000 | |
| Inventory | Low | $100,000 | 50% | $50,000 |
However, the liquidity of an asset is also affected by the context. “For example, if the real estate market is very good, then the liquidity of the assets increases,” said Lemay.
Lenders will also look at the phase the business is in to adjust its loan-to-value ratio. “When a business is growing and is profitable, financial institutions will currently calculate a loan-to-value ratio as high as 100% in commercial and industrial real estate in regions where the market is hot,” he says.
How can you improve your loan-to-value ratio?
To improve your loan-to-value ratio, you can pay down debt. “There’s always a way to make advance payments with your surplus cash,” said Lemay.
However, focusing on improving your loan-to-value ratio is not always the most advantageous strategy for a company.
“A growing company probably has more to gain by continuing to invest, up to a certain point, in order to benefit from leverage. For example, to continue to grow, it might borrow again to acquire a competitor—a transaction that will strengthen its position in the market.”
To determine whether your loan-to-value ratio should be high or low, you need to look at where your business is in its lifecycle.
“A growing business is a bit like someone in their 30s; they are taking on a lot of debt, up to a certain limit, to build wealth,” Lemay says. But a mature business is like someone closer to retirement; it’s not the time to increase debt; it’s more appropriate to pay it off.”