SBA LENDING

Debt Service Coverage Ratio: How a Lender Computes It

By Baruch Mackliff, the Capital Commander · PRBE Capital

Topic: SBA lending, explained without the brochure

Ask a lender why a profitable business was declined and the answer is often a single number you have never been shown. Debt service coverage is that number. It is the test that decides whether the cash the business actually produces is enough to carry the payments it already has plus the payment you are asking for, and it is computed from documents you filed months ago rather than from anything you can improve this week.

Which is the reason to understand it now, before the application, rather than after the answer.

The ratio, and what it measures

Coverage is cash available to service debt, divided by the debt service required over the same period. It comes out as a multiple. A result of one means the business produces exactly enough to make the payments and not a dollar more. Anything under one means it does not.

Lenders are not looking for one. They are looking for cushion, because the ratio is built on a year that already happened and the loan has to survive years that have not. A figure comfortably above one says the business can absorb a bad quarter, a price increase from a supplier, or the loss of its largest customer, and still pay.

Two things the ratio is not. It is not profit, because profit runs through non-cash charges that coverage adds back. And it is not a measure of how well the business is run. A strong operator with a short-amortisation loan can show weak coverage, and the fix is the loan, not the operating.

The numerator starts on a tax return

This catches owners out more than anything else in the process. Your accounting software is supporting evidence. The filed return is the number, because it is the figure you signed and swore to, and the lender will usually pull a transcript from the tax authority to confirm the copy you handed over matches what was actually filed.

Where the analyst starts depends on the entity. A corporation return has taxable income. A pass-through return has ordinary business income before the owners' distributions. A sole proprietor's business schedule has net profit. From there the analyst works down a worksheet of additions and subtractions, and every line on it is arguable.

Interim statements do matter. Most lenders look at the last filed year plus a current period, and they compare the two. A strong interim period against a weak filed year raises a question rather than settling one, and answering it well takes reconciled statements rather than a printout.

The add-backs a lender will accept

The point of an add-back is to strip out things that reduced taxable income without taking cash out of the business, or that will not happen again.

• Depreciation and amortisation. Non-cash, added back on every file, never argued about.
• Interest expense on debt that is being refinanced by the new loan, or on debt whose payment is already counted in the denominator. Add it back once. Counting it in both places is the most common arithmetic error in a self-prepared package, and it always inflates the ratio in your favour, which is exactly why an analyst checks it first.
• One-time, documented, non-recurring costs. A legal settlement, storm damage, a relocation, the start-up cost of a location that is now open and trading. Documented is the operative word. A schedule with invoices behind it gets allowed. An assertion in a cover letter gets struck.
• Rent paid to a related landlord when the loan is buying that building. The rent stops, the mortgage payment starts, and the lender models the swap.
• Owner compensation and discretionary spending, but only within limits. In a change of ownership, the seller's compensation comes back and a market salary for whoever will actually run the business goes in. In a refinance where the same owner stays, the add-back is limited to what will genuinely stop. Personal expenses that ran through the business will keep running through it, and a lender that has read a few hundred of these knows that.

The subtractions owners never see coming

The worksheet cuts both ways, and this side is rarely mentioned until the answer comes back.

• Distributions needed to cover tax on pass-through income. An owner of a pass-through pays tax personally on income the business earned. The cash to pay that tax has to leave the business, so the lender deducts it. Owners who look only at add-backs consistently overestimate their own coverage for this reason.
• Maintenance capital expenditure that is not being financed. Equipment wears out. If the business has to replace a vehicle every few years out of cash, that is a real annual claim on cash flow and it comes off.
• Personal living requirements and personal debt service, once the analysis goes global.
• Payments on obligations of an affiliated business the owners also guarantee. Lenders look through the structure.
• Rent that will start, a lease that is renewing at a higher rate, or a key employee the business is about to have to hire.

Business coverage and global coverage are two tests

The business-only ratio asks whether the company can carry the company's debt. The global ratio widens the frame to include the owners: personal income from every source, and personal debt service, meaning the residence mortgage, vehicle notes, student loans, instalment debt and the minimum payments on personal cards.

Global coverage is where a file with a healthy business ratio can still fail, and the reverse also happens. An owner with substantial outside income can rescue a marginal business ratio. Ask the lender which test is being applied to your request and what the figure is under each, because they are different numbers and only one of them is usually quoted to you.

The arithmetic, on a hypothetical file

Take an operating company with a filed pass-through return. These figures are illustrative, chosen to show the shape of the worksheet rather than to describe any real business.

• Ordinary business income from the return: 141,872
• Plus depreciation and amortisation: 48,231
• Plus interest expense on the debt being refinanced: 22,431
• Plus a documented non-recurring legal cost: 11,748
• Less distributions required to cover tax on the pass-through income: 33,127
• Less maintenance capital expenditure that is not financed: 27,918
• Cash available to service debt: 163,237

Against that, the debt service the file has to carry:

• Existing term debt, annual principal and interest: 47,221
• The proposed loan, annual principal and interest: 81,312
• Total annual debt service: 128,533

Divide and the coverage is 1.27. Now watch what one contested line does. If the analyst refuses the non-recurring legal cost because there are no invoices behind it, cash available falls to 151,489 and coverage drops to 1.18. One undocumented add-back moved the ratio by nearly a tenth, and on a file sitting close to the floor that single missing folder is the decline.

What the number has to be

The agency's operating procedures set a minimum coverage figure a little above one for a 7(a) request, and most institutions add their own internal floor on top of it, which is usually higher. Both move. Ask the lender two separate questions: what do you underwrite to, and what did you calculate on my file.

Treat the floor as a floor, never as a target. A file that lands exactly on the minimum has no room in it, and lenders stress the number before they approve it, re-running the calculation at a higher interest rate or with a haircut to revenue to see what survives. Coverage that only works at today's rate is not coverage.

Historical and projected figures are also weighted differently. Projections are accepted in defined circumstances, such as a change of ownership or a business with a short operating history, and they need support behind them. A projection persuades far less than a filed return, and it invites a second round of questions.

What actually moves the ratio before you apply

The denominator is the faster lever, and almost nobody uses it.

Clear short-amortisation debt first. A small balance repaid over a few months carries an enormous annual debt service, because annual debt service is a function of term far more than of balance. Daily or weekly payment products are the clearest case: a modest advance can consume more annual cash than a term loan several times its size. Retiring one of those before you apply can move coverage more than a strong trading quarter will.

Lengthen the term rather than chasing the rate. The same balance amortised over a longer period reduces the annual payment and lifts the ratio. This is the real argument behind a debt refinance use of proceeds: the point is not a lower rate, it is a payment the cash flow can carry.

Do not add debt in the run-up. A new equipment note or a new advance taken two months before the application lands in the denominator, appears on the personal credit report, and shows on the schedule of liabilities you have to sign. There is no version of the file where it does not.

Decide how the return will be filed before it is filed. A return prepared purely to minimise tax also minimises the income a lender can see, and once it is filed it governs the whole year. That trade-off has consequences in both directions and it belongs in a conversation with your accountant well before the filing deadline, not after.

Build the add-back schedule as the year happens. Every non-recurring item you want allowed needs a document behind it. Collecting those in the same week you are trying to close is how good add-backs get struck.

Time the request. Lenders read the last filed year plus a current period. Applying just after a weak filed year and just before a strong one is the worst possible timing for the same business.

What to ask the lender

Ask for the worksheet. Ask which figure was used as the starting point and which return it came from. Ask which add-backs were allowed and which were refused, and why. Ask whether the test was business-only or global. Ask what the internal floor is and how far above it you landed. Then ask what the ratio becomes under the lender's own stress assumptions.

A lender who cannot answer those is not the lender to spend six weeks with.

PRBE Capital works with owners at exactly this point: rebuilding the coverage calculation from the returns before a lender does it, finding the add-backs that will be refused for want of documents, and deciding whether the honest next step is to apply now or to clear a payment first. The first conversation costs nothing and promises no approval.

This is an explanation of how lenders calculate debt service coverage, not legal, financial or tax advice. Minimum ratios, accepted add-backs and underwriting policy differ by lender and change over time, so confirm the current requirements with your lender and your own accountant before acting on any of it.

Common questions

What is a debt service coverage ratio?

It is cash available to service debt divided by the debt service required over the same period, expressed as a multiple. A result of one means the business produces exactly enough to make its payments and nothing more. Lenders want a cushion above one, because the ratio is built on a year that already happened and the loan has to survive years that have not.

How do lenders calculate debt service coverage from a tax return?

They start from taxable income, ordinary business income or net profit depending on the entity, add back non-cash and non-recurring items, then subtract real claims on cash the return does not show. The result is divided by the annual principal and interest on existing debt plus the proposed loan. Filed returns govern, and most lenders confirm them against a transcript from the tax authority.

What add-backs will a lender allow?

Depreciation and amortisation always, interest on debt being refinanced or already counted in the denominator, documented one-time costs such as a settlement or a relocation, rent that stops when the loan buys the building, and limited owner compensation adjustments. The word that decides most of them is documented. A schedule with invoices behind it gets allowed and an assertion in a cover letter gets struck.

Why is the lender's coverage number lower than mine?

Usually because of the subtractions rather than the add-backs. Distributions required to cover tax on pass-through income, unfinanced maintenance capital expenditure and payments on affiliated obligations all come off the top, and owners calculating their own ratio rarely include them. Double-counting interest is the other common cause, and it always flatters the borrower.

What is the difference between business and global debt service coverage?

The business ratio asks whether the company can carry the company's debt. The global ratio adds the owners' personal income and personal debt service, including the residence mortgage, vehicle notes and card minimums. A file can pass one and fail the other in either direction, so ask which test is being applied and what the figure is under each.

How can I improve my coverage ratio before applying?

Work on the denominator, because it moves faster than the numerator. Clearing short-amortisation debt has the largest effect, since annual debt service depends on term far more than on balance, and a small balance repaid over a few months can consume more cash than a much larger term loan. Avoid taking any new note in the months before you apply, and build the add-back documentation as the year happens rather than during the closing.

What coverage ratio do SBA lenders require?

The agency's operating procedures set a minimum a little above one for a 7(a) request, and most institutions apply their own internal floor above that. Both figures change, so ask the lender what it underwrites to and what it calculated on your file, which are two different questions. Treat the floor as a floor rather than a target, because lenders re-run the ratio at a higher rate or with a revenue haircut before approving it.