If you are thinking about buying a business, it is essential to understand the financing options that are available for purchasing a small business.
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It's even more important to understand how decisions are made regarding those financing options. For example, when is a bank willing to finance a small business acquisition and when are they likely to decline a business acquisition loan request?
The key factor in determining financing options for buying a business is whether the earnings from the business are sufficient to service the debt and pay the new owner a salary.
Debt Service Coverage Ratios
Lenders want to know where the cash flow is coming from to cover the debt.
The first thing they will do is look at the money that is being generated by the business (often referred to as Seller's Discretionary Earnings) and subtract the proposed new owner's salary to see how much money remains to service the annual debt of the proposed loan.
So let's say the business has positive cash flow that generates $200,000 to cover the owner's salary and interest.
You indicate to the bank that you will be taking a salary of $90,000 out of the business. That leaves $110,000 to cover debt.
Lenders looks at these numbers and use something called the Debt Service Coverage Ratio to determine how much they are willing to lend you, if they are willing to lend at all. It's one of many factors lenders use to decide if they will give you a business loan to purchase the company you are interested in.
Banks not only require the Net to cover the Annual Debt but to also provide for a cushion. This cushion, or Ratio, gives the business the ability to cover debt in the event future revenues or profits decline. Many lenders like to see a Debt Service Coverage Ratio of 1.25 – 1.5 or higher.
In the example above, here is how the lender might use Debt Service Coverage Ratios to decide what level of financing you might qualify for. The first thing the lender will do is determine how much money is available to service the debt:
Seller's Discretionary Earnings
minus New Owner's Salary
equals Net (after New Owner's Salary)
The lender then takes the Net amount ($110,000) and divides it by the target Debt Service Coverage Ratio to get a satisfactory Annual Debt payment amount.
For example, if the lender is targeting a Debt Service Coverage Ratio of 1.25, they would be willing to finance a business loan with an Annual Debt payment of no more than $110,000 / 1.25, or $88,000 per year.
If you were interested in getting a larger loan, where the Annual Debt payment was $150,000, would the bank be willing to lend to you?
No way. Your owner's salary plus your Annual Debt exceed the free cash flow, i.e. the Seller's Discretionary Earnings, that the business is projected to deliver. At that level of lending, you are a loan default waiting to happen.
How about going the other way? What if you wanted a bank loan that had a $50,000 Annual Debt payment?
In this case, the banker will likely be very happy to make the loan. The Debt Service Coverage Ratio would be $110,000 / $50,000, or 2.2. That's a low-risk proposition for a banker.
How Does the Banker Know the Numbers Are Real?
If you've followed everything so far, you might be wondering about that $200,000 number we used above.
Suppose you tell the banker "The business will have cash flow of $200,000."
Does the bank take your word for it?
Why not just say that the business will have cash flow of $500,000? Then you're sure to get the loan, right?
Not so fast. Bankers don't just look at your pro forma financials and rely on projections for future earnings and cash flow.
They look at the target company's historical accounting records, primarily tax returns, for the company in question to see if the Debt Service Coverage Ratio would have been satisfactory to them in the past if the business in question had had the financing in question during that prior time period.
They typically want to see that these ratios work on the last three years of Seller's Discretionary Earnings(SDE). SDE is calculated by adding the net profit of the business, owner salary and discretionary owner expenses. The bank will also want to see that the Seller's Discretionary Earnings trends in the current year also look positive.
Debt Service Coverage Ratios are an important part of the small business lending decision-making process, and you now understand how they work.
This gives you a leg up on your peers who just go into the bank asking for a business acquisition loan without fully understanding how small business loans work.
Remember, although lenders look at many factors in making a business acquisition loan, if the earnings of the business will not pay the new owner a salary and service the debt, they will not make the loan.
A qualified business broker can walk you through the specifics of a given transaction and let you know what level of business acquisition loan you might qualify for. It's a smart move to have this conversation long before you start talking to bankers.
In future articles, I will talk more about small business acquisition financing, from the perspective of the buyer, the seller, and the creditor. I will also cover other topics related to buying a business and selling a business.