Debt Service and available cash calculation
September 02, 2024
by a searcher in Chicago, IL, USA
I have a question regarding calculating DSCR and what other metrics Banks look at, that are perhaps more valuable than DSCR.
For example, if DSCR is 1.5 x it may still be a bad deal but DSCR doesn't necessarily reflect the amount of cash available to service debt.
Are there more important metrics Banks use and if so, what are they?
Any advice when looking at DSCR and cashflow modelling on deals would be appreciated. Thanks
from Eastern Illinois University in 900 E Diehl Rd, Naperville, IL 60563, USA
1) Borrower / Team experience. Whether you have direct industry experience or relatable experience, understanding the team buying a business is very important. The most experience you can bring to the table or are retaining with key management makes a huge difference in how comfortable lenders will get.
2) The amount of equity injected into the transaction. The more Borrower equity the more comfortable a lender gets. However, seller notes, seller roll-over or retained equity, and even earn-outs (non-SBA financing) help lower the loan-to-cost and get lenders comfortable.
3) The debt service coverage ratio ("DSCR"). What is required can vary greatly depending on the lender and loan type. For SBA 7A loans the minimum required by the SBA is a 1.15x DSCR, but most lenders required between a 1.25x and a 1.50x DSCR depending on the type of transaction and the amount of goodwill exposure. Also, most lenders want to see minimum DSCR ratios hit over multiple periods, with preference to the last two tax years, YTD, and TTM periods. If you are doing more conventional financing lenders usually like to see those ratios at 1.35x to 1.50x minimum.
4) Future CAPEX needs of the business. Although this can be tightly tied into cash flow, I often see potential buyers over-look the CAPEX needs of a business. If you have a business that generates $2 million in EBITDA but the average spend on fixed assets each year the past three years is $1 million, then once you adjust for potential future CAPEX needs you really only have $1 million in free cash flow. You have to have future plans to support CAPEX needs for the business.. This is often where I will see buyers get caught up in thinking they have more cash flow then they really do once CAPEX is factored in. Lender's will look hard to be sure future CAPEX needs have been properly taken into account with the cash flow analysis.
5) Accounting for the working capital needs of the business. Even though adjusted EBITDA may be $2 million, if you have a high revenue and low margin business, you need to be sure there is enough working capital left in the business to cover operating expenses. If a business does $24 million a year in revenues with $2 million in adjusted EBITDA, then in theory (not factoring in debt service for the new loan) you would need at least $2 million in working capital to support the business for just one month. Many businesses with A/R and inventory turns end up needing more than that. And part of that working capital has to be in cash to cover immediately payroll and other expenses. Being sure you do a deep dive on what the working cash needs of the business are is very important as well. Lender's will look hard to be sure there is adequate working capital to support the business post-closing.
6) Revenue, margin, and profit consistency. Lenders always prefer to lend on businesses where revenues are stable or growing and margins are relatively stable or consistent. Businesses that have had large swings in revenues, margins or profits always make lenders more nervous.
7) Industry concerns. Many business have industry risks that cause lenders to be concerned. The higher risk the industry, the harder it can be to get lenders comfortable.
8) Balance sheet strength. Most lenders want to see that business has solid balance sheets or will have a decent balance sheet post closing where it is not over-leveraged or at least not too over-leveraged from a senior debt position. Although with SBA financing, you will see some very leveraged balance sheets and it is less of a concern with SBA financing then with more conventional financing.
9) Guarantor strength. Lenders typically want to see adequate guarantor support based on the size of the transaction, including having post-closing liquidity or assets that could help support the transaction should a need arise. Borrowers with limited to no net worth are highly unlikely to be able to secure $5 million plus in financing. Although there is no set ratio and it can vary depending on the deal, I usually find most lenders want the Borrower / Guarantor(s) net worth to be between 5% to 20% of the transaction amount (again, varies depending on the lender) .
Again, this list is not all inclusive and is not in any order. I usually tell my clients I find lenders, especially in the SBA world, tend to focus up front the most on buyer experience and the DSCR. The rest they really dig into during underwriting. If you have additional questions you can reach me here or directly at redacted
in Rawalpindi, Punjab, Pakistan