When dealing with financing of various sorts you will come across the term “coverage ratio”. It my be in the context of “Interest coverage ratio” or “debt coverage ratio” or some other similar nomenclature.
Here’s the basic concept of a coverage ratio. The coverage ratio is designed to determine what margin for error there is in a borrower’s ability to pay back the debt.
Let’s use an example assuming you are buying a business, here are some basics:
- Business Purchase Price $500,000
- Seller’s Discretionary Earnings (SDE) $175,000 (Seller’s discretionary earnings is the business earnings before Interest, Depreciation, Taxes, Amortization and Owner’s Compensation).
- Down payment Buyer has available $100,000
- SBA Loan $400,000 financed for 10 years @ 7% = $4,644 per month payment which = $55,750 per year.
- Salary the Buyer needs from business to pay living expenses $100,000.