Loan-to-value ratio
To take out a secured loan, you must pledge a valuable asset to guarantee repayment. If you cannot repay the loan, the lender can seize and sell this asset to pay themselves back.
The market value of the asset used as collateral is the typical price that would be paid for this asset on the market. If the asset pledged as collateral is relatively easy to convert into cash, you’ll be more likely to be able to obtain a bigger loan. For example, marketable securities are easier to convert into cash than a building.
François-Xavier Lemay, Manager, Business Centre, BDC, explains how to calculate this ratio and how banks and other financial institutions use it.
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 requested loan by the market value of the asset the business uses as collateral.
The market value given to an asset can vary depending on the context and the financial institution. It may be lowered if the asset has low liquidity, such as a building.
To convert certain assets into cash, the bank may be required to take several steps that will take time. This process often comes with associated costs, such as hiring a real estate broker for a building. The institution factors in this cost by reducing the asset’s market value.
Sample calculation of loan-to-value ratio
Here’s a sample calculation for a business that wants to purchase a $1-million building. A certified appraiser may determine the market value. The buying company and the building owner can also agree on an amount to carry out the building’s sale.
The company wants to invest $200,000 in the project and is applying for a loan of $800,000. So, the loan-to-value ratio would be 80%.
Secured loan amount: $800,000
Market value of the building: $1,000,000
“The loan represents 80% of the asset's market value,” explains Lemay.
How do financial institutions use the loan-to-value ratio?
The loan-to-value ratio is one of the things that banks look at before they agree to a loan. “It’s reassuring for banking institutions to see that the value of the assets meets or exceeds the value of the loan,” says Lemay.
However, this ratio isn’t the only factor that financial institutions consider. They also look at:
- the company’s profitability
- cash flows
- industry trends
- equity
“To pay back its loan, the company has to turn a profit. It won’t be able to do that if it’s losing money,” says Lemay.
What factors influence the loan-to-value ratio?
Based on the situation, financial institutions don’t use the same loan-to-value ratio for all asset types.
Asset liquidity levels
Banks will lend at a higher ratio if they can easily convert the asset into cash. The following chart shows how the loan-to-value ratio can vary between asset types.
Chart 1: Example of loan-to-value ratio variation based on asset type
| 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/industrial real estate | $100,000 | 65% to 100% | $65,000 to $100,000 | |
| Inventory | Low | $100,000 | 50% | $50,000 |
The chart presents different asset types, their liquidity, market value, the loan-to-value ratio and the maximum loan amount.
For example, $100,000 of marketable securities used as collateral allows for a maximum loan of $90,000. However, $100,000 of inventory used as collateral only allows for a loan of $50,000.
Context
The context can also affect the liquidity of an asset. “For example, if the real estate market is very good, then the liquidity of the assets becomes greater,” notes Lemay. As a result, the loan-to-value ratio can increase.
The company’s growth
Financial institutions will also look at the growth phase that the business is in to adjust its loan-to-value ratio.
“When a business is experiencing strong growth and is profitable, financial institutions can calculate a loan-to-value ratio as high as 100% in commercial and industrial real estate in regions where the market is hot,” Lemay says.
Can a loan-to-value ratio be improved?
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,” says Lemay.
However, focusing on improving your loan-to-value ratio isn’t always the most advantageous strategy for a company.
“A growing company probably has more to gain by continuing to invest, up to a certain limit, to improve leverage capabilities. For example, to continue to grow, it might borrow again to acquire a competitor—a transaction that will strengthen its position in the market.”
How to determine an acceptable loan-to-value ratio
To determine whether your loan-to-value ratio should be high or low, you need to look at where your business is in its life cycle.
“A growing business is a bit like someone in their 30s; they’re taking on a lot of debt, up to a certain limit, to build wealth,” explains Lemay. “As the person gets closer to retirement, a bit like a more mature business, it’s not the time to increase debt but more appropriate to pay it off,” he added.
Download our free digital guide to learn more about how to get a business loan.