LOANOLOGY

RATIOS & CASH FLOW

KEY RATIO CALCULATIONS

Debt Service Coverage Ratio (DSCR)

The debt service coverage ratio (DSCR) is critical to loan approval.

This is how it is calculated:

Annual EBITDA / Annual Debt = DSCR

For startups this is based on projections. For purchasing a business this is based on the combined profit of the buyer and seller.

This ratio is a reflection of available free cash flow after paying all expenses and debt service payments.

For startups this is based on projections. For purchasing a business this is based on the combined profit of the buyer and seller. This ratio is a reflection of available free cash flow after paying all expenses and debt service payments.

Maximum Loan Amount

Once the DSCR is established, the maximum loan amount comes into view. The calculation is simple: EBITDA / DSCR = Maximum Annual Debt Service. However, the minimum acceptable DSCR can vary. Startups rely heavily on projections, with the loan amount depending on carefully selected DSCR values, such as 1.15, 1.25, or 1.50. For existing businesses and acquisitions, higher profitability allows for more leniency. The optimal loan amount is determined by dividing the combined EBITDA by the required DSCR values, such as 1.50 or 1.75.

Loan to Value (LTV)

While the SBA hasn’t set hard and fast rules for Loan-to-Value (LTV) ratios, many of its lenders implement internal LTV policies to manage risk. These internal policies typically cap LTV at 90% for SBA loans. In contrast, conventional lenders have a narrower window, with maximum LTV requirements typically falling between 75% and 85%. This variance in LTV policies can be a decisive factor in a financial advisor's loan application outcome: one lender might extend 100% bank financing, while another may necessitate a down payment, or require a portion of the purchase price to be financed by the seller.

Given that LTV is calculated by combining the value of the buyer's and seller's practices, acquisition deals generally bypass LTV qualification hurdles. However, LTV ratios become a crucial challenge in conventional loans when the buying advisor’s practice is valued at or below 33% of the selling practice’s value. In such scenarios, the loan agreement could breach the LTV maximums set by conventional lenders, pushing the need towards an SBA-backed loan. For SBA loans, the threshold of concern is when the buyer’s practice is worth approximately 11% of the seller's; this figure is a trigger point for exceeding conventional LTV limits, necessitating the pursuit of an SBA lender for financing.

Debt-to-Income Ratio (DTI)

Banks go the extra mile to examine the borrower's personal financial health. Some employ the same DSCR methodology used for the business, evaluating personal cash flow and debt obligations. Others use the DTI = Personal Annual Debt Service / Total Personal Income. Typically, banks look for values under 30%-40%.

Net Worth

While there is no set net worth-to-loan ratio, net worth plays a significant, yet understated, role in the loan approval process. A strong net worth, evidenced by retirement accounts, home equity, and investments, instills confidence and reduces perceived risks, especially in the case of startups. Conversely, a low net worth may necessitate down payments, even when they are not officially required.

Leveraging Cash Flow for Growth and Stability

How DSC Impacts Approval

For acquisitions, potential cash flow becomes a critical focal point for lenders. While criteria may differ, cash flow must meet specific thresholds to qualify. The favorable terms of SBA loans, including a generally lower Debt Service Coverage (DSC) requirement and a more attractive Loan-to-Value (LTV) ratio, significantly enhance borrowing capacity for advisors. These loans can reach up to $5 to $7 million, particularly advantageous when factoring in the lower DSC benchmarks that SBA lenders often employ. For instance, while the SBA generally sets a minimum DSC at 1.15, individual lenders may opt for higher internal benchmarks of 1.25 or 1.50. Traditional lenders, on the other hand, may look for a DSC of 1.50 or 1.75, though some may show leniency regarding previous years' financial performance.

The implications of these varying requirements are profound; under the more lenient SBA guidelines, advisors can access as much as 30% more funding compared to a conventional lender seeking a 1.50 DSC benchmark, and a staggering 52% more when contrasted with lenders enforcing a stringent 1.75 DSC minimum. Additionally, even among conventional lenders, a policy shift from a 1.50 to a 1.75 DSC could facilitate nearly 17% more in available loan dollars. Such financial metrics significantly influence the lending landscape, illustrating the critical role of cash flow in securing necessary capital for growth and stability in the advisory profession.

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