When a business owner comes to you for a loan, you’re responsible for assessing the four C’s of credit: character, capacity, collateral, and cash flow. Together, these metrics help you determine whether or not a small business can reliably pay back a new loan. Cash flow is the most critical of the four as it’s the actual source of the borrower’s loan payments.
That’s why we deeply focus on the mechanics of cash flow in our CI101 course, the first in the Community Impact Finance Professional (CIFP) certificate training program series. The goal is to give you the tools to structure a deal that still works, even when the numbers come up short.
Here, we’re giving a sneak peek at our CIFP course curriculum, covering how to calculate adjusted cash flow, use it to find debt service coverage ratio (DSCR), and structure a loan around a cash flow shortfall.
All about cash flow, adjusted cash flow, and DSCR
Cash flow is the money moving in and out of a business and includes what it actually has on hand to cover expenses, payroll, and debt payments at any given time. It differs from net income and profit, as a business can look profitable on paper and still not have the cash to make payments, or it can generate plenty of cash flow without showing a profit at all.
However, not every dollar of cash flow on a business’s books is available to make loan payments. Reported net income reflects tax and accounting choices, which is why lenders use adjusted cash flow instead.
Adjusted cash flow is a business’s cash flow after adding back non-cash expenses like depreciation and amortization, plus one-time costs, providing the true cash available to cover debt payments.
That number leads you to another key metric: debt service coverage ratio (DSCR), which is the ratio between income and payments on existing debt. This value ultimately determines whether the business can take on additional debt.
To calculate DSCR, divide the total available cash flow by the total debt the business is to take on. This includes the new loan, plus any additional debts in the process of being repaid.
The SBA benchmark for DSCR is 1.15 to 1.25. A DSCR in this range means the business has a cushion above breakeven and is a sign that it can make their loan payments. This, along with additional factors, tells you whether cash flow will cover payments for the loan you’re evaluating.
Use the adjusted cash flow analysis alongside additional factors
Before you give the loan your stamp of approval based on the adjusted cash flow and DSCR analysis, it’s important to also analyze the following factors:
- Historical performance: A look at a business’s past performance in terms of financial results, cash flow, and repayment history
- Pro forma projections: Forward-looking financial reports that use estimates to forecast future performance
- Global cash flow: A cash flow analysis that looks at the owners’ personal finances, too
Together, these factors give you a full picture of your client’s financial standing. We explore this further in our coursework.
Your plan if the numbers fall short
If the DSCR falls below the SBA benchmark, that doesn’t mean you have to decline the loan. Often, a low DSCR comes down to structuring—which refers to how the loan itself is set up, or what other financing sits alongside it. One or more of the following strategies can often move the loan forward:
- Lengthening the amortization period, which lowers the monthly payment
- Adding seller carry-back, where the seller finances part of the sale and the buyer pays them directly
- Layering in standby debt, where a secondary lender holds off collecting payments until the SBA loan is paid off
- Bringing in an equity injection (down payment) from your client, which lowers the loan amount needed
- Consolidating higher-cost debt, which lowers monthly payments and improves the DSCR
- Moving to a seasonal payment schedule, so larger payments land when cash flow is highest
If those won’t work, consider restructuring or phasing the project, or encourage the borrower to cut costs and reduce the loan size needed by leasing instead of purchasing or buying used instead of new. You can also choose a program better suited to the business’s existing cash flow structure.
The right loan program can make cash flow work
Along with the strategies above, you can also choose a program better suited to the business’s existing cash flow structure. The following program options can help get the numbers where they need to be:
- The SBA 7(a) loan’s longer repayment term means smaller monthly payments, which directly improves DSCR.
- The SBA 504 program offers a low down payment and a favorable fixed rate on 40% of the total project costs, lowering both the down payment and ongoing monthly payments.
- The USDA B&I loan works the same way as a 7(a) loan and serves businesses in rural areas.
- The Economic Development Administration (EDA) can provide longer term, lower-rate subordinate lending that fills the gap between what the main loan covers and the total cost of the project rather than just increasing the primary loan.
Opening up these options gives your client a route that works for them, and the more you know about adjusted cash flow analysis, the better equipped you are to guide them to the right choice.
Go deeper with Grow America’s CIFP certificate program
The adjusted cash flow analysis runs through the whole underwriting process and determines whether you can move forward with the loan. To go deeper into this analysis, including how factors like a business’s operating cycle and permanent working capital come into play, consider enrolling in Grow America’s CIFP certificate program.
We offer in-person, virtual, and self-paced classes that give you the tools to evaluate your client’s cash flow—and the confidence to get more small businesses to “yes.”