Most lenders want a 1.25 debt service coverage ratio or DSCR. This means the business you’re listing needs $1.25 coming in for every dollar going out.
This is so important when taking on a listing, and is often overlooked by a lot of business brokers. We talk with a lot of business intermediaries who are only valuing a business based on multiples and not on the amount of debt coverage that the business can service.
In fact, sometimes they don’t even factor this in at all when going to market with a business listing. This could be your kiss of death and could complicate things down the road.
Why Should I Care About The Debt Service Coverage Ratio Of My Listing?
More than likely, any potential buyer will probably have to get financing for the purchase of the business and will require a third-party institution to finance part of the transaction. This lender will focus primarily on the business’s ability to service a certain amount of debt based on the current cash flow, which we call the debt service coverage ratio (DSCR).
Let’s keep this simple as I am a simple person. The business must show that it can afford a specific payment and verify this with specific evidence from prior years and the current year.
An institution will only fund a scenario it feels comfortable with. This starts with the business’s ability to show evidence that a loan of a certain size can be serviced by the cash flow of the business including covering its debt.
This is the first litmus test it must pass to justify a specific price point. If it does not pass this test, then the buyer will have to come up with additional cash or the seller will have to lower the price to accommodate for the shortfall.
Maybe a seller note can be structured for the difference. However, this will probably have to be on standby for the life of the loan because we have already established the business can’t support this amount.
Debt Service Coverage Ratio Formula With Examples
Now, I mentioned a term called “debt service coverage ratio”. So, what is this ratio I am speaking of, and where is the sweet spot for where it needs to be for lenders to feel comfortable?
Most lenders like to be at a 1.25 DSCR. There are some instances that it can be less but let’s just focus on this number right now. This means that for every $1 going out, there needs to be $1.25 coming in.
Like I said before, I am a simple man, and this is a simple explanation. So, let’s look at an example.
Let’s say a business is netting $100,000 per year after all add-backs that we can take along with adding in a salary for a potential buyer. Let’s say the amount we are trying to finance for the transaction is $500,000.
If we take $500,000 x 10 years (the loan period) x 6% interest, the payment for this amount would be $66,612 per year. If we take the cash flow of $100,000 and divide it by the yearly loan payment which is $66,612, we get a ratio of 1.5.
This example would be over and above the magic debt service coverage ratio of 1.25. Most institutions like to be around this number so this listing would probably be a deal an institution would be comfortable lending to.
If we wanted to finance $750,000 in this same DSCR example it would not work and here is why. If we take $750,000 x 10 years (loan period) x 6% interest, the payment would be $99,912 per year. If we divide $100,000 / $99,912 we get a ratio of just a little over one which would be well below the 1.25 magic number.
Ouch, this would not be a deal an institution would be interested in financing. Just one bad month in sales or an unexpected equipment repair would possibly jeopardize the new business owner’s ability to pay this loan.
Now, there is one extremely important point I would like to make and if you just do this moving forward you will have so much more success and less stress in your business brokering career.
Please allow a bank to analyze the financials of your business listing before you go to market. They will do a debt service coverage ratio and be able to tell you the amount a potential buyer can borrow to purchase this business before you even list it. We sometimes call this in the business a “pre-qualification”. I don’t know about you, but this would make me feel a lot more comfortable when going to the market.
What A Pre-Qualified Business Listing Will Do For You
A pre-qualified business will allow the current business owner to understand from day one how a bank is going to look at their business, so it is easier as a broker to have conversations with them.
You will be able to set the business listing at a price that is in line with someone being able to finance it from day one. It will give confidence to a potential buyer to see the possibilities of how they can finance this transaction and give them the satisfaction that a bank has analyzed the deal and likes it.
It will also allow you to vet potential buyers because we will tell you what the qualifications will be for a potential buyer for this business. You will not waste time with people who are not qualified. You will know what the buyer needs to look like which will also give you the ability to target-market the listing to those specific individuals rather than the masses.