January 17, 2023
If you are looking to get an SBA loan to buy a business, expand a business or start a business the SBA will require lenders to demonstrate that the business can cash flow the proposed loan.
In this article I want to explain what it means when your lender says “the business doesn’t cash flow” and how you can run different scenarios and forecasts to see what amount and structure of an SBA loan you should be able to qualify for from a cash flow perspective.
Here is what I plan to cover:
But before I jump into it, just a bit of background. I am not an attorney, CPA or even an SBA lender today, but I do have a unique set of experiences related to SBA lending and cash flow projections. I spent a decade as the Executive Director of an SBA lender called Bankable. We made loans to small businesses that were not yet able to get a loan from a traditional bank utilizing the SBA Microloan Program and SBA Community Advantage program.
In addition to my work at Bankable, I started ProjectionHub to help founders create financial projections for potential lenders and investors back in 2012. Since that time we have helped over 50,000 entrepreneurs create financial projections.
So with the mix of SBA lending and financial forecasting in my background I wanted to try to answer some key questions for small business owners that are looking to get an SBA loan and discuss the intersection of SBA lending and financial projections.
I thought so too, let’s dive in.
What are the Cash Flow Requirements for an SBA Loan?
In order to qualify for an SBA loan the bank that is making the loan and applying for an SBA guarantee will need to write a credit memo that should document whether the business has sufficient cash flow to repay the proposed SBA loan. If you can’t make a case for the business having enough cash flow to repay the SBA loan, the SBA will not provide an SBA guarantee which means the SBA lender will not be willing to make the loan.
The standard requirement for an SBA loan is that the business should have a debt service coverage ratio (DSCR) of 1.25 or greater.
What does this mean?
This means that the bank needs to make the case to the SBA that the business will have 1.25x the amount of cash flow that it needs to be able to make its loan payments. If your DSCR is 1, then you have exactly enough cash flow to meet your loan payment obligations. A DSCR of 1.25 means you have $1.25 of cash flow for every $1 of loan payments that you need to make.
How does the SBA Measure Cash Flow?
The big question is how does the SBA or your lender calculate how much cash flow your business has? The reality is that it is going to fluctuate from lender to lender and from specific deal to specific deal. Let me explain a bit more.
What is Debt Service Coverage Ratio?
Debt service coverage ratio is calculated by taking net operating income divided by your debt service, which is your principal and interest payments.
But if you are applying for a new SBA loan your future debt service will be different once you have the SBA loan payments to include. So your lender needs to take net operating income divided by what your debt service will be once you have the SBA loan.
If you are an existing business and looking for an SBA loan for your current business, you can expect that your lender will take your previous year tax returns to identify your net operating income. They will probably use your previous year, or maybe even take an average of the last few years to come up with your net operating income for the debt service coverage ratio calculation.
Now what if you are getting an SBA loan to grow your business or getting a piece of equipment that will make you more efficient and thereby more profitable? Your net operating income will actually increase once you have the SBA loan. You might not have a 1.25 DSCR with the new proposed SBA loan based on your previous years of tax returns, but your projected DSCR might show sufficient cash flow to qualify for the SBA loan.
So how do you make your case to the SBA lender that you will have sufficient net operating income to meet their DSCR requirements? You will need to create a set of projections to try to make your case.
How to Calculate your Debt Service Coverage Ratio Forecast?
In order to forecast your debt service coverage ratio, you will first need to create a set of financial projections in order to determine your forecasted net operating income. You will also need to forecast your annual principal and interest payments on debt.
Let’s assume you are looking to buy a business and secure an SBA loan to fund the acquisition and you need to make sure that your DSCR is at least 1.25. You can use our acquisition financial projection spreadsheet to create a forecast based on the historical financial performance of the target company plus your expected changes to the business. You can also enter in your expected loan terms and any seller note details related to the acquisition and our template will automatically calculate your forecasted DSCR.
Once you enter in your assumptions you will be able to see your Net Operating Income and DSCR for the next 5 years as seen below:
Net Operating Income Forecast
Debt Service Coverage Ratio Forecast
In this example you can see that in year 1 of our forecast we have a 1.91 DSCR, but it drops below the 1.25 threshold in year 2 and 3 because we were forecasting to add some salaried positions that impacted net operating income.
How to Improve your Debt Service Coverage Ratio?
To improve your debt service coverage ratio you will need to increase your net operating income or reduce your principal and interest payments on your debt. One common way to do this in an acquisition is to utilize a seller note where the seller note is on full standby to the SBA loan which means you won’t have to make payments on the seller note until the SBA loan is paid off. If you can finance a portion of the acquisition price with a seller note and reduce the amount that you were going to borrow this will have the impact of lowering your debt service initially and helping to increase your DSCR. You can see an example of how you can enter in a seller note in our acquisition template below:
How to Calculate How Large of an SBA Loan you Might Qualify for?
The dollar amount of an SBA loan that you will qualify for will be in part a function of how large of a loan you can cash flow. In other words, how large of a loan can you maintain a debt service coverage ratio of 1.25.
So one way to back into a loan request amount is to figure out the maximum loan amount that allows you to keep a 1.25 DSCR. You can use our template to play around with different scenarios with different loan amounts, terms, seller notes, growth rates of the business, etc in order to see what loan amount you might be able to make a case for when acquiring a business.
How to Calculate a Sales Price for your Business that Will Qualify for SBA Financing?
One last thing I wanted to highlight. If you are looking to sell your business, it can be really helpful to price your business at a dollar amount that will make it easy for a buyer to qualify for an SBA loan. For example, if your business produced a net operating income of $125,000 last year, then your buyer would in theory only be able to afford annual debt service of $100,000 in order to maintain a 1.25 DSCR. You can play around with different loan amounts, terms, interest rates and seller note terms in order to find a sweet spot with debt service of less than $100,000. You can use a loan calculator to play around with different options. For example, I assumed a loan of $1 million over 10 years at 8% which amounted to a monthly payment of $12,132 which is too high to maintain a 1.25 DSCR.
Assuming the same 10 year term and interest rate, the loan would need to get down to around $700,000 in order to bring the monthly payment low enough to cash flow. In that case you would have a few options:
- You could reduce your sales price
- You could ask the buyer to put in more equity to reduce the loan amount
- You could increase the size of a seller note in order to reduce the SBA loan amount
As a seller of a small business, if you want to have the best chance at closing a sale, you should consider pricing your business at a level that your net operating income can support an SBA loan for financing the acquisition. If you price your business outside of what qualifies for an SBA loan you are severely limiting the number of potential buyers that might be able to acquire your business.
I have focused a lot on the acquisition of a business, but these same cash flow requirements apply if you are an existing business that is simply looking for an SBA loan to grow the business, so I hope you will be able to use these tips to help determine how much your business might able to qualify for with an SBA lender, and what levers you can pull to increase what your business might qualify for with the SBA.
If you have any questions about your specific situation or need help creating a forecast please let us know!