Requests for business acquisition financing are invariably met by a key question posed by prospective lenders. They want to know if the enterprise to be purchased will produce enough income for the new owner - the borrower - to be able to repay the loan. Of course there will be a need to provide collateral, probably assets of the business and perhaps other security offered by the borrower. But even if the lender will receive enough security interest in the buyer/borrower's personal or real property to cover the amount of the loan, it still will be necessary to demonstrate that the cash flow of the business will generate sufficient funds to meet the debt obligation.
And, as most buyers and all loan officers know, the profit and loss statements on the business that the seller provides, are unlikely to show all of the actual earnings the seller collected. Quite possibly, the buyer will collect enough money as owner of the business to meet the loan payments. Yet a look at the historical P&L's might not make that obvious. That's when it's necessary for the lender to understand the actual earnings expected by the proposed borrower, and it's up to the borrower to explain where the money will come from to support the monthly principal and interest payments.
As the prospective borrower points out cost items that don’t actually take any cash, as well as optional and one-time costs listed in the expense column, he wants to add the figures accompanying those entries to the bottom line; and then make the case that with these additions, there will be enough funds to pay off the loan as required. And while this is a very common and accepted practice, buyers can run into problems if not careful to include only legitimate addbacks in applications for business acquisition loans.
Depreciation Might Not Be A Legitimate Addback
The practice of treating depreciation as a non-cash expense is based on the assumption that the depreciable, or economic life of a capital asset is considerably shorter than its useful life. In other words, it's usually assumed that the $50,000 value of a manufacturing machine, for example, can be written off in three to five years, while it actually will be used on the production line for ten years or longer. And typically, the money theoretically set aside specifically for the purpose of replacing that machine will not be needed for several years. That’s why the depreciation figures assigned to that piece of equipment are considered non-cash costs that might appropriately be addbacks - funds available for other purposes, including the payments needed to get out of debt. This sum might not be a legitimate addback, however, if the equipment is nearly ready to be "retired," and the depreciation fund will actually be needed to replace it. In that case, the depreciation entry is not a "phantom" expense that can be added to the owner's actual earnings, but a real cost that will need to be paid.
When Personal Expenses Can't Be Used to Pay for Business Acquisition Loans
Also problematic is the attempt of a prospective borrower to convince a loan officer that certain expenses shown on the business P&L are actually for the seller's personal benefit and those amounts can be added back to earnings. That may be the case in some situations, but a loan applicant needs to be sure that the claim is accurate.
One common example is the cost of leasing, servicing, fueling and insuring the seller’s vehicle. If the vehicle is not needed for the business, it may be correct to argue that expenses associated with it can be added back to earnings. But the vehicle costs cannot and should not be added back if, for example, the new owner will need a car or truck to make deliveries.
Another personal expense that shouldn't be added back could be country club dues. Yes this looks like a non-business expense, unless the lender digs deeper and learns that the new owner will rely on the relationships cultivated at the club to sell the company’s products and services. Especially if that has been an important marketing strategy for the seller.
Help Available To Buyer/borrower In Recasting Earnings Statements
By correctly identifying seller expense entries, on business P&Ls, that can be added back to earnings and used for debt service, buyers often can strengthen their applications for business acquisition loans. But they can run into trouble if the addbacks aren't chosen correctly, or explained effectively.
That’s when it might be useful to seek the aid of a small business loan specialist with experience in helping buyers/borrowers prepare persuasive loan applications and get them reviewed by suitable lenders and financial institutions.