What on earth is a coverage ratio in financing with an SBA Loan?

What on earth is a coverage ratio in financing with an SBA Loan?

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.
Coverage Ration Calculation  
SDE                                       $175,000
Salary needed                         $100,000
Available for Debt Service      $75,000
Amount of Debt service          $55,750
Coverage ratio is                     1.35   Amount available for debt service divided by actual debt service.
Generally speaking when seeking an SBA Loan the coverage ratio required will be between 1.25 and 1.4.

What Price is the Right Price to buy a Small Business

If you decide you want to buy a business you need to prepare yourself for the rather inconsistent pricing methodologies used for setting the asking prices for small businesses.

You shouldn’t confuse the asking price for a business with the value of the business or what finance professionals call a Business Valuation or Business Appraisal. There are many ways to compute the value of a small business. The results can be wildly different and all correct. The issue isn’t “what is a business worth?” as much as “what is the business value to you?”. We’ll breakdown the elements and suggest ways for you to go about the process of determining a fair value for a business.

For background it also might be helpful to read  “What do you Buy when you Buy a Business?” . Also, you might want to review this Case Study How to Buy a Business –  Case Study.

In this post we will discuss the elements that create small business value. As Business Brokers we have these discussions with buyers but more importantly we have the same discussions with business sellers.

Here are the key elements that drive the value of a business up or down. Investigating these elements will help you create your own business valuation to determine what price is reasonable:

  • Stability of Earnings.  A business with consistent earnings is worth more than a business that has wild swings in it’s profits year to year. The small business profits are what allows a business buyer to pay down the loan (debt) used to buy the business. The reason small business profits are so instrumental in buying a business is simple…….. a business can never pay the current year’s expenses with next year’s profits. If you buy a business with consistent profits you will be able to borrow more to finance the purchase and therefore you can pay more with lower risks due to the consistent cash flow.
  • Customer Concentration – A company with 100 customers all doing 1% of the revenue is worth more than a business with one customer doing 70% and 3 others doing 10% each. If the customer that represents 70% of the business revenues leaves the business is in the tank. This can be a very important issue for the SBA loan if needed to buy a company. If you plan to use an SBA Loan for acquisition financing this will be closely scrutinized.
  • Business has a high barrier to entry – Not many businesses have this but, if it does, it’s worth a lot. The barrier to entry could be patents, highly recognized brands, special equipment not easily duplicated, exceptional location, etc. But beware, if the business has one of these it should be reflected in the business by delivering higher profit margins than average for the industry.
  • Management/Employee responsibilities – The less the owner of the business is involved the more the business is worth. In his book Built to Sell author John Warrilow describes how this characteristic creates value. Also, Michael Gerber has written a great book E-Myth that talks about applying these principals to small business. If you are serious about buying a business I would highly encourage you to get both of these books and read them before you begin your business search.
Now here’s a simple pricing model you might use. When looking at a business take each of the 4 elements above and score them on a scale of 0 –  4, with 4 being the best. 
Let’s say you’re looking at a widget shop. The Widget Shop has seller’s profits of $100,000 per year. You score the business this way on the above 4 categories 3,2,2,3. The average of those is 2.5.
Then simply multiply the business profits of $100,000 times 2.5 and you get $250,000. Using the above assumptions $250,000 is a reasonable value of the Widget Shop.
As you might imagine there are many resources to help you value a business. The book Small Business Valuation is especially good. Also, there is a great software package that includes Valuation and Business plan all in one called Business Plan Pro (we highly recommend this terrific business success tool.)
If you decide to buy a business you need to have some information and knowledge so that the asking price isn’t the only reference point.
Remember, it’s not what you pay relative to the asking price that’s important, it’s what you pay relative to the value to you that’s important.

Business Library of Excellent Books

Confidentiality when Buying a Business

A lot of things can go wrong when buying a business. Here’s some background on the Importance of Confidentiality. If you want to buy a business….understanding this issue can be the difference between buying a business and losing a good opportunity. Below is a 2 minute video discussing the importance of confidentiality when you buy a business:

Minute video Confidentiality in a Business sale

Note: Please note that this information is copyright protected and can not be reproduced without the written consent of Sunbelt Business Brokers Houston Texas or Dan Elliott. 

How to Make an Offer to Purchase a Small Business

Buying a small business is a unique process in many ways. Here is a list of “elements” of a contingent offer that might make sense when considering a purchase.

Contingencies are very important when making an offer. A buyer is not likely to get full access to all of the business books and records without first agreeing to a purchase price and terms CONTINGENT on full due diligence. Contingencies to consider when making an offer:

  1. Small Business Financing – If you will need financing include a contingency for obtaining small business loans on terms and conditions acceptable to you.
  2. Include a contingency for buyer and seller to agree on a specific training and transition plan.
  3. Contingency for any agreements to be assumed by buyer to be on terms acceptable to buyer (example, facility leases, copier contract, machinery leases, etc)
  4. Contingency for background check on the business and the seller’s themselves. It’s important for buyer to know who they are buying the business from.
  5. Contingency for full review of all business records including tax returns, sales tax reports, bank statements, etc.

As always, reassure the seller that you understand the confidential nature of this information. Those 5 contingencies above are a start to buy a business, some specialized businesses require more specialized contingencies. For instance there could be a case where a particular supplier is extremely important to the business, a contingency might be for the vendor to approve buyer and agree to continue to supply the buyer after closing.

These kinds of 3rd party approvals can be very tricky, get good advice before heading down this path. Think through your small business ideas and build your contingencies to make sure that you’ve covered all the bases.