DSCR For A Business Acquisition Loan: How Lenders Test Cash Flow

What DSCR Means

DSCR compares the cash a business produces with the debt payments it will owe after you buy it. The formula is simple:

DSCR = cash flow available for debt ÷ total annual debt payments

SBA defines the starting point as EBITDA (earnings before interest, taxes, depreciation and amortization), divided by the combined debt service after the purchase. Combined means everything: the SBA loan, any seller note you will be paying, equipment loans that stay with the business and any other debt used in the deal.

A DSCR of 1.00 means the business earns exactly enough to make its payments, with nothing left over. Lenders want a cushion, because a slow quarter, a lost customer or a broken truck should not mean a missed payment.

The SBA Minimums By Deal Type

SBA sets the floor by the type of change of ownership:

Most readers of this guide are doing an Initial Acquisition, so 1.25 is your number. If you already own a business and are buying a competitor, read our guide to add-on acquisitions, where the lower 1.15 can apply.

These are SBA minimums. Some lenders want more, especially in industries they see as risky, and that is a lender preference, not an SBA rule.

Which Year The Lender Uses

The lender looks at the business's three most recent fiscal years, using the best financial statements available: audited first, then reviewed, then CPA-compiled, then tax returns. It also reviews the current year-to-date financials alongside the same period last year.

To pass the DSCR test, the lender can use either:

• The last fiscal year end, or
• The average of the last two fiscal years

That choice matters. A business that grew last year often passes on the most recent year but not on the average. A business that had one bad year may look better averaged. The interim numbers still matter too: if this year is running well below last year, expect hard questions.

What the lender cannot do is rely on your projections. SBA requires lenders to review your post-closing plan but not to use it to meet the DSCR minimum. Your plan to raise prices or add a second crew is welcome in the business plan. It just cannot carry the loan. The one exception is a special purpose property, like a hotel, where the real estate fully secures the loan.

Add-Backs: Getting From Net Income To Cash Flow

Tax returns understate the cash a small business produces, because owners run legitimate personal and one-time costs through the company. Lenders adjust for that with add-backs. SBA lists the kinds of adjustments a lender may justify, including non-recurring income, distributions, seller discretionary expenses and owner compensation. It may also count savings the purchase itself creates. If the building comes with the business, the lender may add back the rent the business will no longer pay.

The rules on add-backs are strict:

• Each one needs a written justification in the lender's credit memo explaining why it is prudent and supported by the business's ongoing operations.
• Unsupported add-backs are thrown out. If the lender cannot document it, it does not count.
• Your own pay has to be realistic. The salary you will draw must cover your personal obligations and living expenses. If the lender adjusts owner compensation, it must run a global cash flow analysis showing your household covers its own debts at least 1 to 1.

On deals with a Business Purchase Price of $3,000,000 or more, a Quality of Earnings report is required, and the lender must use the QoE's earnings in the DSCR. For the full list of what passes and what does not, read SDE and add-backs.

Worked Example: A Pest Control Company

You are buying a pest control company for $2,200,000. The lender gives you an estimate of the annual payments on the SBA loan it is proposing, and the seller has agreed to a small seller note that you will pay alongside it.

At 1.29, the deal clears 1.25. Look at how thin the margin is, though. The maximum annual debt the business can support at 1.25 is $352,000 ($440,000 ÷ 1.25), so there is only $12,000 of room.

Now suppose the lender will not accept the $20,000 legal settlement because the seller cannot document that it was one-time. Adjusted cash flow drops to $420,000 and DSCR falls to 1.24. The deal fails by a hair. That is why documentation for every add-back matters as much as the add-back itself.

The year matters too. If the year before showed $380,000 of adjusted cash flow, the two-year average is $410,000 and DSCR on the average is 1.21. Here the lender would rely on the most recent year, which SBA allows.

How Seller Notes Change The Math

How the seller is paid has a big effect on DSCR:

• A seller note on full standby takes no payments of principal or interest for the life of the SBA loan, so it adds nothing to annual debt payments. It can also count toward up to half of your Down Payment. See seller notes on full standby.
• An amortizing seller note adds its full annual payment to the calculation, like the $40,000 above.
• An interest-only seller note is tested as if it amortized over no more than 10 years, even if the actual note has no principal payments yet.
• A note on partial standby, such as 24 months, still has to fit once payments start.

Here are two closed deals that used seller notes repaid alongside the SBA loan:

Real loans we placed. Borrower and lender names are kept private. See all closed deals.

For how to structure these notes, read seller financing with an SBA loan.

What To Do When DSCR Comes Up Short

If the numbers land below 1.25, you have options before you walk away:

1. Put more money down. SBA lets you add unlimited or limited equity to shrink the loan and its payments until coverage works.
2. Move the seller note to full standby. Its payments drop out of the calculation entirely.
3. Renegotiate the price. A lower price means a smaller loan. A DSCR shortfall often signals the valuation will be tight too.
4. Include the real estate. If the business owns its building, the real estate portion can be repaid over up to 25 years, which lowers annual payments, and the rent add-back can help.
5. Document the add-backs better. Invoices, receipts and a CPA's explanation can rescue an adjustment that would otherwise be rejected.

Check A Deal Before You Make An Offer

Before you sign a letter of intent, take the last full year of tax returns, add back the obvious items, subtract a fair salary for yourself and divide by a rough estimate of the annual payments. If you land well above 1.25, you have room. If you are near it, expect the lender to push back. Our SBA calculators and the guide on how much business you can afford help you size it.

For a lender's view of your numbers before you commit, request a pre-qualification letter. You can also read the full overview of SBA business acquisition loans.