The number one reason small business banks decline borrowers is lack of cash flow. Even though the SBA will provide its SBA bank with a guarantee for a substantial portion of the borrower’s loans, banks are still obligated per SBA rules to make sound business loans.
Remember that SBA banks are “cash flow” lenders. They want to see that the business has adequate cash flow to pay back the principal and interest. SBA banks are not “asset based” lenders who focus on fully collateralized loans. Sure, they would love to have more collateral than less, but an abundance of collateral does not make up for a lack of cash flow.
Here is a rule of thumb to keep in mind – banks will want to see that cash flow from the business is at least 1.15x times the loan payments for the business. Put another way, the cash flow from the business needs to be at least 15% more than loan principal and interest payments – “debt service” in banking vernacular. Bankers call this the debt service coverage ratio (“DSCR”):
DSCR: Cash flow / Loan payments > 1.15
How do I calculate cash flow from my small business?
To determine cash flow from the business, banks will review both financial statements and tax returns. Since most businesses are cash basis taxpayers, we will focus on reviewing tax returns to determine cash flow for our illustrations. Most small businesses file a partnership/LLC return (Form 1065) or a S-corporation return (Form 1120-S). For these small businesses cash flow is calculated this way:
Ordinary business income (Line 21 of 1120-S or Line 22 on 1065)
+ Depreciation Line 14 (1120-S) or line 16a (1065)
+ Excessive owners’ compensation? (1)
= Total cash flow
(1) Some banks will allow a borrower to add back “excessive” owners’ compensation into the calculation of cash flow if the owner(s) do not plan to take excessive compensation from the business post-closing. For example, if an owner typically makes $100,000 per year but the last three years pays herself an end of the year bonus of $300,000, the bank may add back some or all of the $300,000 as excessive compensation since the excess is really viewed as business profits that the entrepreneur simply paid out as wages instead of dividends or business profits.
Banks vary regarding their treatment of owners’ compensation. As a rule of thumb, the owners’ personal compensation needs are included as a business expense, and the remainder is considered cash flow from the business. And that could vary per geography (e.g., the personal cost of living in New York City is vastly different than the cost of living in Colorado Springs). Some bankers have suggested to us that $50,000 – $75,000 in a generalized baseline for owners compensation but obviously that varies based on geography and the borrower(s) personal financial situation. Using the numbers from above, a bank may look a solo entrepreneur whose business makes $300,000 that is 100% paid to the owner at the end of the year as having a $50K – $75K salary and business profits of $250K – $225K.
Once you have determined your annual cash flow – we recommend starting with your 2019 tax return as a guide – you will be able to calculate the maximum loan amount given various DSCRs. Note that none of the lenders in our network are below a 1.15x DSCR, and very few are above 1.25x.
Our Excel SBA loan calculator can be downloaded and modified to calculate different scenarios (e.g., longer term or different interest rates). We used a 10-year term and 6.5% interest rate for illustrative purposes are those are common elements of loans we have seen in 2020. However, real estate loans can be as long as 25 years.
In addition to calculating cash flow for 2019, it is especially important that you also calculate 2020 cash flow numbers as well as many lenders are extremely sensitive to the impact that Covid has had on sales and cash flow. Businesses that have seen their 2020 cash flows plummet and continue to stay at a low level relative to 2019 are finding it very difficult to find a loan and those who do obtain financing are seeing their loan capacity being based on the lower 2020 cash flow numbers.
The below graphics show you exactly where to find the most important data points for prospective SBA banks – gross sales, owners’ salaries, depreciation, and ordinary business income – on your business tax returns.
Still confused? Reach out to us and we will be happy to answer any of your questions to the extent that we can. We aren’t bankers and we don’t work for the SBA, but we do talk to SBA bankers every week who do nothing but SBA loans all day, every day.