Understanding the Debt Coverage Ratio & SBA 7(a) Loan When Buying a Business
When it comes to buying a business, securing the right financing is crucial. One of the most popular financing options is the SBA 7(a) loan, which is favored for its flexibility and favorable terms. A critical aspect of qualifying for this type of loan—and indeed managing any business loan effectively—is understanding and calculating the Debt Coverage Ratio (DCR). Here’s what you need to know about the DCR and SBA 7(a) loans when purchasing a business.
What is the Debt Coverage Ratio (DCR)?
The Debt Coverage Ratio, also known as the Debt Service Coverage Ratio (DSCR), is a financial ratio that measures a business's ability to repay its debts through its net operating income. It is calculated by dividing the business’s net operating income by its total debt service (the total amount of principal and interest payments due over a given period).
Formula: Debt Coverage Ratio (DCR)=Net Operating Income (NOI)/Total Debt Service
A DCR of 1 means the business’s net income is equal to its debt payments, indicating a breakeven point where the income just covers the debt service. Most lenders look for a DCR greater than 1. Typically, a DCR of 1.25 or higher is preferred, as it indicates that the business generates enough income to comfortably cover its debt obligations by a margin of 25%. However, it's far more comfortable if that number is 1.5 or greater.
Why is DCR Important for SBA 7(a) Loans?
When applying for an SBA 7(a) loan to purchase a business, lenders use the DCR to assess the risk associated with the loan. A higher DCR reassures the lender that the business can withstand financial downturns while still meeting its debt obligations. Since the SBA guarantees a portion of these loans, banks are encouraged to lend to businesses that might not qualify for traditional loans, but they still require a good DCR to mitigate their risk.
Key Features of the SBA 7(a) Loan
Eligibility and Use: The SBA 7(a) loan can be used for purchasing a business, refinancing existing debt, and/or providing working capital.
Loan Amounts: The maximum loan amount for an SBA 7(a) loan is $5 million.
Terms and Interest Rates: The terms and interest rates for SBA 7(a) loans can vary depending on the amount and use of the loan. Generally, the terms can extend up to 10 years for business acquisitions and up to 25 years when the business acquisition also includes real estate. Interest rates are based on the prime rate plus a margin.