Debt service coverage for small business acquisitions
Check acquisition debt coverage before an LOI by reconciling seller earnings, replacement compensation, capex, working capital and seller-note payments.
Before sending a letter of intent, work out what cash the business could produce after paying for the operations you intend to run. Then compare that cash with the acquisition debt payments. A price that looks reasonable against seller-adjusted EBITDA can still leave too little money to operate through a difficult year.
This is an early screen for a searcher or micro-PE buyer. Keep the assumptions visible, identify the records needed to test them, and take the proposed structure to your lender and advisors before treating it as financeable.
Define the ratio before using it
Debt service coverage ratio, or DSCR, compares an earnings or cash-flow measure with debt payments over the same period. Scheduled principal belongs in the denominator alongside interest. BDC's DSCR explanation describes an EBITDA-based calculation and the need to understand how a bank defines it.
For your own cash-flow screen, write the calculation explicitly:
Buyer cash coverage = cash available for debt service ÷ scheduled principal and interest.
Label this as your buyer calculation. A lender's DSCR may use a different numerator or treatment of particular obligations. Ask for its calculation rather than assuming your spreadsheet reproduces it. Lenders set their own coverage thresholds. SBA and lender requirements change, so confirm current terms with your lender.
Coverage of 1.00x means the defined cash amount exactly equals the included debt payments. It leaves no surplus within that calculation. A higher number does not establish financing approval or tell you whether cash arrives before payments fall due.
Reconcile the CIM figure to your operating plan
Start with the seller's earnings reconciliation for a named period. Keep reported EBITDA, each seller adjustment and the seller-adjusted total separate. The first-pass CIM checklist explains how to preserve the earnings label and source before making your own adjustments.
Ask what supports each add-back and whether the expense will disappear under your ownership. An expense described as unusual may recur in a different form. A family member's salary may pay for necessary work. Leave unsupported adjustments out of the case you rely on, and retain them separately as unresolved seller claims.
Adjusted EBITDA from a CIM is not the same as cash available for debt service. Your operating plan still needs to account for replacement labor, equipment spending, cash tied up in operations and taxes. BDC's lending assessment overview illustrates why lenders may adjust EBITDA for cash demands such as taxes and unfunded capital expenditure.
Use the quality of earnings preparation guide to turn gaps in this reconciliation into questions for your financial diligence provider. Do not relabel an early buyer estimate as verified earnings.
Put the owner's work back into the cost base
List what the seller actually does, including estimating, sales, supervision and administration. Decide which duties you will perform and which require another employee or outside provider. Budget the full replacement cost, including relevant benefits and payroll costs.
Check what compensation the starting earnings figure already includes. If the seller added back all owner compensation, your case needs a replacement allowance. If adequate replacement compensation is already expensed, subtracting it again understates coverage. Explain any incremental adjustment beside the calculation.
Include a realistic compensation budget for your own operating work. Treating your labor as free can make a transaction appear more comfortable than the income you need permits. Keep compensation for work separate from any additional distributions you hope to receive as an investor.
Budget cash that earnings do not settle
Ask for equipment history and a replacement plan. Separate maintenance spending needed to keep current operations running from spending intended to support growth. If growth is in your revenue forecast, include the investment needed to deliver it. Do not improve coverage by postponing essential equipment work without an operating explanation.
Review monthly receivables, inventory and payables. Estimate the additional cash operations may absorb after closing, including seasonal needs and slower collections. Distinguish that change from the working capital delivered at closing: the opening funding requirement and later cash absorption answer different questions.
Build a tax cash allowance with your advisor for the proposed ownership structure. Keep one-time transaction costs and opening liquidity in sources and uses so they are funded separately. Document where each cash demand appears to avoid both omissions and double counting.
Include seller notes in the payment schedule
Build the denominator from the proposed schedules for every debt obligation the acquired business will service. Separate principal from interest, identify payment start dates, and include seller-note payments when due. Reconcile any debt assumed or refinanced at closing with the post-close schedule.
A seller note with deferred payments changes timing. It does not erase the obligation. Model when payments begin, any interest that accumulates, and any balloon payment. Ask the lender how the note affects its underwriting and what terms it will accept. Do not assume a proposed deferral is agreed or that refinancing will be available at maturity.
Work through one acquisition screen
Synthetic example. The business, earnings, cash allowances and debt schedules below are invented. These are buyer planning assumptions, not lender terms, tax estimates or SBA requirements.
A searcher reviews a service business whose CIM reports annual adjusted EBITDA of $800,000. The seller has added back all owner compensation. The buyer assumes $150,000 of annual replacement compensation, including employment costs, and rejects $50,000 of other unsupported add-backs.
The base case makes no growth assumption. All amounts below cover the same first full year after closing. Transaction costs and opening liquidity are assumed separately funded. There are no other debt payments or additional discretionary distributions in this illustration.
| Base-case cash bridge | Annual amount |
|---|---|
| CIM adjusted EBITDA | $800,000 |
| Less unsupported add-backs | ($50,000) |
| Less replacement compensation | ($150,000) |
| Buyer operating earnings before the cash deductions below | $600,000 |
| Less maintenance capex paid from operations | ($60,000) |
| Less additional cash absorbed by working capital | ($40,000) |
| Less assumed tax cash allowance | ($50,000) |
| Cash available for debt service | $450,000 |
The assumed senior loan schedule requires $260,000 of principal and $70,000 of interest during the year. The seller note requires $20,000 of principal and $10,000 of interest. Total debt service is $260,000 + $70,000 + $20,000 + $10,000 = $360,000.
Buyer cash coverage is $450,000 ÷ $360,000 = 1.25x. Cash remaining after the included debt payments is $90,000. Neither result is a lender approval threshold or a promise of a distributable amount.
Now test a downside for the same business. Assume weaker trading reduces buyer operating earnings by $90,000, from $600,000 to $510,000. Slower collections increase working-capital absorption from $40,000 to $70,000. Keep maintenance capex at $60,000 and the tax cash allowance at $50,000 as an explicit simplifying assumption pending advisor review.
Downside cash available is $510,000 − $60,000 − $70,000 − $50,000 = $330,000. With debt service unchanged at $360,000, coverage is approximately 0.92x, and the annual cash shortfall is $30,000. The base-case surplus disappears under these operating assumptions.
Turn the result into an LOI decision
Identify which assumptions need evidence before you propose terms. Could a different price or additional equity reduce scheduled payments enough? Is replacement compensation understated? Does the downside expose a collections problem that needs more diligence? Revise the structure and rerun the case rather than treating an unfunded shortfall as something to solve after closing.
Also inspect monthly cash timing and later years when seller-note payments change. Annual coverage can conceal a seasonal cash gap. Bring the cash bridge, debt schedule and unresolved questions to the lender, then use the LOI preparation guide to connect the proposed terms with financing and diligence conditions reviewed by counsel.
SearchWare's acquisition underwriting lets you save and compare scenarios and inspect coverage and sensitivity. Review the model's definitions with your lender and advisors. Bring one acquisition case to a SearchWare trial, and check plans and included features.
See also: Quality of earnings for searchers | A first-pass CIM checklist | Search fund LOI template