Net Income After Tax vs SBA Loan Payment

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October 31, 2024

by a searcher from Northwestern University - Kellogg School of Management in Chicago, IL, USA

My understanding is that DSCR = (adj EBITDA)/(amortized loan payment per year) is one of the key metrics SBA 7a lenders look at (among many other things), but at the same time, only the interest portion of the loan payment is tax deductible and principal part is not.

If the above info is true, shouldn't we take estimated net income tax expense into consideration when checking the DSCR? Thanks a lot

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Reply by a searcher
from Babson College in Long Island, New York, USA
EBITDA - estimated tax is definitely a more accurate numerator for DSCR on an annual basis, but I think the reality is that in most cases, if you acquire a small business, you're going to have enough D+I+A for the first several years to reduce your income tax significantly. so if you have a EBITDA/debt service ratio of greater than 1.2 (my preference is >1.5) , you should be fine. if your taxes go up it will only be because profits go up. and if you drop below 1 DSCR it's almost definitely going to be due to something other than high corporate income taxes.

add that to the fact that calculating accurate corporate income taxes taking into account all possible deduction and tax optimization strategies is not that straight forward, I think you hit the law of diminishing returns pretty quick and EBITDA based DSCR is a pretty good proxy.

That said, you should model out your net after tax cash flow for yourself and any equity investors.
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Reply by a professional
from Bentley College in Miami, FL, USA
You're absolutely correct in noting that DSCR is typically calculated as Adjusted EBITDA / Annual Loan Payment. Lenders often focus on EBITDA as a proxy for cash flow, as it excludes the impact of taxes and non-cash expenses, allowing for a clearer view of the business's ability to meet debt obligations before taxes.

To address your specific points:

-- Interest Deductibility: As you mentioned, only the interest portion of the SBA loan payment is tax-deductible, not the principal. This means that, while the EBITDA metric offers an approximation of cash flow, it doesn’t reflect the cash taxes the business will ultimately need to pay.

-- Tax Impact on DSCR: Although DSCR is calculated on a pre-tax basis using EBITDA, it’s wise for buyers and business owners to consider the after-tax cash flow impact, especially when assessing whether the business will still have adequate cash flow after tax payments. A high tax burden could erode cash available for debt service, making it harder to meet obligations even if the pre-tax DSCR seems sufficient.

-- Practical Application: Many lenders understand that EBITDA doesn’t account for tax payments and look for a DSCR of 1.25x or higher as a buffer. For your analysis, you might calculate an estimated post-tax cash flow to assess how much margin you have left after debt payments and taxes, ensuring there’s ample coverage.

In short, while DSCR is pre-tax, factoring in after-tax cash flow provides a more conservative view, helping ensure the business won’t face cash flow issues due to tax liabilities.
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