Before you get your loan, and before you know that you have any hope of buying that business or expanding this one or getting that new restaurant open, you will need to prove that there is enough cash flowing to cover the payments. At the end of the day, the lender wants to feel confident that the business is going to generate enough cash to pay back its loans.
This article describes exactly what lenders are looking for when they assess whether a business has “enough” cash flow. It also explains why your job as the entrepreneur is to lay out not one but several different versions of the story about how things are going to go. That helps you plan, and also helps your banker assess which story they can believe in.
The “credit memo” is the internal document at the bank that explains exactly what is going on with the deal. The document explains whether the business can actually make the payments. If the memo is not clear on cash flow, then SBA won’t guarantee the loan and you are out of luck.
Most lenders are looking for at least 1.25 x the required debt service. In finance, that is called the “debt service coverage ratio”, or DSCR.
What does that mean?
It means that for every dollar you owe the bank, you have $1.25 coming in. In other words, the annual cash flow should be at least 125% of the annual debt service. If your DSCR is 1, you have exactly enough cash flow to cover your loan payments.
How You Measure Cash Flow
How you measure cash flow varies a lot from one lender to the next, and from deal to deal. It is critical to know how your lender is going to calculate things, and what will and won’t count as cash flow.
In its simplest form, the ratio is the net operating income (NOI), divided by the required debt service. Total debt service means adding up all your payments of interest and principal due in a year.
If you are trying to get a new SBA loan, you will use this formula to figure out whether you will be able to make the payments. The lender checks cash flow based on what the numbers will look like once the new SBA loan is in place.
Your lender will look at your tax returns and the other numbers from the business. Those are your “historical” numbers. For a new loan on an existing business, the NOI usually comes from the tax return from the last full fiscal year. In some cases they will use the average of the last few years.
But the history is not the only version of the story. Another version is that a loan for new equipment will make you so much more efficient that profits will rise. You might not have covered 1.25 x on your old tax returns, but you might clear it going forward because of how much more efficient the new equipment makes you.
Tell the lender the story about why you believe you will have enough cash to make the payments. Write up the numbers, and compare them to the history. When they do your underwriting, your banker might agree to use the higher number for the business when they calculate the debt service coverage ratio.
Cash Flow Projection
One common way to calculate your debt coverage ratio is by making a cash flow projection. Your projection should be split into two parts. One part is the debt service schedule, which shows your interest and principal payments each month. The other part is your forecast of cash in each month and out each month.
For example, say you are trying to use SBA to buy a small business. Your target DSCR is at least 1.25.
Lay out what the next five years are likely to look like. That forecast should tell two stories. One story is what your net operating income is projected to look like each year. The other is what your DSCR is projected to be in each year.
Say that in year 1 of your forecast, the debt coverage ratio is 1.91 times debt service. In other words, for every dollar you owe on the loan, you will have $1.91 coming in. That is well over the minimum 1.25 x level. For years two and three, cash flow falls below the minimum. In this case, that makes sense because of the added payroll costs.
There are only two basic ways to make things right. First, you could bring in more NOI and cash flow. Another way to make DSCR work is by lowering the payments instead of raising cash flow. If the terms are right, a seller’s note can shrink the loan you need. If the seller’s note is on full standby, it can also reduce the payments while you are getting things rolling. On full standby, the seller agrees not to ask for payments until the main loan from the bank is fully paid off.
The Maximum Loan Size
Do you know what the maximum loan size is that your cash flow will allow? A given amount of cash flow can only carry a limited amount of debt.
If you want to know the rough maximum amount of loan you are eligible for, estimate your NOI for next year. Divide that by 1.25. That number is the most you will be allowed to pay out in principal and interest next year.
If you are the seller, to attract a buyer using SBA you need to understand what financing terms work for your buyer. Say the business generates $125,000 a year in net operating income. At a 1.25 x debt service coverage ratio, the bank will allow a maximum annual debt service of about $100,000 a year. But a 10 year loan at 8% interest on $1 million is $12,132 a month. That is too much debt service, because at 125% coverage, the maximum that is allowed to pay each year is $100,000.
That would push the loan down to about $700,000 at 8% for 10 years.
One way to make the deal work is by bringing the price down. A lower price means a smaller loan, which means lower payments and higher debt service coverage.
The seller could go along with a smaller loan at the same purchase price. The buyer would put in more of their own cash.
Or the seller could leave the sale price the same, but defer part of what they get paid through a bigger seller note.
If you want your business to be SBA finance-able, price it to fit within what your income can support. It is critical to know how the math will work for a buyer with an SBA loan. At a certain price, a SBA buyer simply can’t make the purchase work. If you set the price too high, you are going to limit your pool of buyers.
Those same rules apply when you are an owner trying to grow your company. Think through your numbers before you go to the bank, so you can estimate the best approach to take and can back up the amount you think you should qualify for.
About Delancey Street
Delancey Street is a premier, and award winning, business debt settlement company that helps business owners nationwide. Our goal is simple: help you escape debt in a safe and legal manner. Based out of New York, we can help in 49 of 50 states. We tell you how it is; because your business and future is on the line.
