Applying for a business acquisition loan can be challenging for someone who hasn't been through that process in the past. If she has a home mortgage or has financed a car purchase, she knows that the value of the property being pledged has to at least equal the amount of the loan. But when it comes to buying a coin laundry, hamburger restaurant, or any other small business, it's almost impossible to come up with an accurate value. That's one of the reasons that lenders are just as interested in understanding the amount of the cash flow of the business - the money that will be used to pay off the debt - as they are in knowing what the enterprise might be worth.
For the smart buyer, this means demonstrating clearly that the business is generating enough funds that the new owner will be able to make the payments on time. Making that point with the lender involves more than just showing the firm's past profit and loss records. It's likely the books don't reveal the total, actual cash flow soon to be available to the new owner.
Many loan executives involved with small business deals understand that the typical business owner will take advantage of tax breaks to lower reported earnings and reduce the size of payments made to the IRS and the state tax collector. They are informed about add backs for personal items and about non-cash expenses such as depreciation and amortization.
Working With Loan Officers
But it's a mistake to assume that the person asked to approve or reject your loan application has the time and the interest needed to analyze every expense item on a profit and loss statement, and to calculate how much money you actually will take out of the business. This is a situation in which the buyer needs to be actively involved, going over each expense item that might belong on the bottom line and explaining, in as much detail as the lender requires, how much money will truly be available for debt service. Recasting the P&L's should be done when preparing the loan application by including a document that points out items such as amortization, and also does the math. The person evaluating the request should be able to easily see the amount each add back contributes to cash flow.
Valid Information Only When Requesting Business Acquisition Loan
This isn't a task for someone who's new to the experience. It's frequently a good idea to ask for help from a small business loan specialist who understands what addbacks to earnings are legitimate, and which will provoke doubt in the mind of the person reviewing the application. Adding back the expense item called "depreciation," and calling it a non-cash expense, is a sensible argument provided there is no need to replace fixtures, tools or machinery in the near future. And the question of the condition and useful life of every item on the depreciation list will be posed by the reviewing loan officer. The borrower had better have the right answer.
Another way prospective buyer/borrowers get in trouble with add back claims on their loan applications is identifying as personal expenses the costs that are needed to operate the business. A loan officer won’t be persuaded that the seller's vehicle expense is all personal - and the amount spent for it can be added back to earnings for use in loan payments - when the truck is used to make deliveries.
Collateral Also Needed In Many Instances - But Not Always
This discussion of cash flow, and the requirement that it is sufficient to support loan payments, doesn't mean to discount the need to pledge assets to secure the debt. The degree to which lenders rely on cashflow figures when reviewing a loan application depends on the type of lender. On one end of the scale are private investors and non-institutional money sources, mostly concerned that there is more than enough collateral - including assets of the business and other borrower property - to secure the loan. If the borrower defaults, they’ll seize and sell whatever assets are needed for them to recoup their loss.
This contrasts with SBA-backed lenders who are particularly interested in the viability of the business to be purchased. They don't want to take ownership of the collateral used to secure the loan. So they look particularly closely at past performance of the business and try to make a conservative prediction about whether it will produce enough funds for the owner to take care of her debt service.
Whoever the lender, the entrepreneur seeking a business acquisition loan needs to make sure the company’s provable earnings will be sufficient to pay off the loan. And then explain it effectively to the lender.