understanding lending coverage ratios
We’ve all heard many of these terms before, but do you really understand a lender when they are telling your borrower that the 1.15 ratio is not in line?
By STEVE MARIANI
JANUARY 11, 2020
We have all heard these terms before, but do you really understand a lender when they are telling your borrower that the 1.15x ratio is not in line? Or that they do have a coverage ratio for last year but not for the most current interims? Today, I take much of the mystery out of understanding coverage ratios beginning with the minimum coverage required for an SBA loan to be approved.
“The Applicant’s debt service coverage ratio (OCF/DS) must be equal to or greater than 1.15 on a historical and/or projected cash flow basis and 1:1 on a global basis.”
We must understand the items needed to complete this calculation, as it cannot be done on a listing alone without including a buyer or an applicant. If you have had any experience with SBA loans in the past, then you might recognize a specific form named “personal family budget” or “personal cash flow analysis” as these forms have many names, but all serve the same function: they are used to determine the actual required salary draw for the new owner/borrower. These forms matter more than you might believe because if the borrower’s salary requirement exceeds the available cash flow of the business, the loan application cannot be approved. The salary amount is deducted from the cash flow of the business prior to determining any debt service and cash flow coverage ratios. Most intermediaries never see the actual living expenses required for a borrower and usually just ask what amount they want to earn. Lenders must go beyond this by correlating the borrower’s personal budget with their credit report to be sure no monthly obligation is being overlooked. Once the lender does this, they can determine the exact amount of required salary for a buyer. Our firm often advises borrowers to keep those expense down to their actual monthly obligations and not include extra expenses which may be considered “optional” such as dinning out, hobbies, et cetera. Once we understand the requirements of the buyer, our focus then turns back to the business cash flow as we continue our calculations on coverage ratios.
Based on the SBA’s coverage rule above, I will now explain how that relates to discretionary earnings of the business. For example, we will consider a transaction value of $1,000,000 with a cash flow of $300,000 in the most recent year. We will also consider the buyer’s salary of $100,000 per year and a down payment amount of 15%. We include working (operating) capital and all closing costs in the overall project cost. After calculating the loan payments to be ~$12,048 per month, that now equates to $~144,576 per year (actual loan payment amount). Next, we must show the lender, and the SBA, that the business can support this transaction when including this coverage ratio. This is where most of the confusion is at as the SBA requires a minimum of 1.15x, but most lenders will require a 1.25x coverage ratio. Let’s now put that in actual numbers. The annual debt expense is $144,576 and the SBA requires $166,262 (1.15) to be shown in the previous full year, and then the lenders will require $180,720 (1.25). Using the above scenario, we then remove $100,000 of buyer salary requirements and $180,000 of debt service (understanding that actual debt service is only $144,576) that provides a surplus of about ~$20,000, which is enough to secure an approval for this transaction.
As you can see from this example, the SBA requires a minimum coverage but most lenders are more conservative and increase that ratio. Many lenders also have different ratios for specific industries, depending upon their portfolio and the performance of each. We do know of a lender that requires a 1.65x coverage for a particular industry. The other item of note is that most lenders do not disclose, unless asked, what ratios are required for the loan application to be considered.
When compiling your offering memorandum, you should be aware of these coverage ratios and understand what listings will secure SBA financing and under what circumstances before going to market. If you know the business will not cover the buyer’s salary requirement or the debt service to at least a 1.25x coverage ratio, I would consider alternative methods of financing for this deal. Knowing that certain industries have higher coverage ratios than others at some lenders, it is important to screen the transaction upfront with the lender you believe will finance the acquisition and will also address this concern immediately to save time.
When considering cash flow coverage ratios, we must review and address the last three years of tax returns (or financial statements) along with the interim financials of the company. The SBA requires 1.15x on the last full year, but nothing on previous years. Lenders may have different criteria (multiple years) when approving the loan application, but this is an internal policy required by that specific lender.
Overall, the most aggressive lenders in the nation can, and do approve, transactions based on only one year of cash flow coverage with the interim trends in line with previous years or higher. Understanding what to present to lenders in your initial OM or loan package will greatly increase your chances of success of securing an approval. If you have a lending relationship, then you should always explore financing options upon securing a listing so the only unknown left to be determined is the buyer’s salary requirement. Knowing what cash is available to a buyer after debt service will go a long way when screening potential buyers.
When it comes to determining cash flow and what is required to complete your transaction, keep the surprises to a minimum and understand what you are presenting before you present it, always!