What on earth is a coverage ratio in financing with an SBA Loan?

When dealing with financing of various sorts you will come across the term "coverage ratio". It my be in the context of "Interest coverage ratio"  or "debt coverage ratio" or some other similar nomenclature.

Here's the basic concept of a coverage ratio. The coverage ratio is designed to determine what margin for error there is in a borrower's ability to pay back the debt.

Let's use an example assuming you are buying a business, here are some basics:

• Business Purchase Price $500,000
• Seller's Discretionary Earnings (SDE) $175,000 (Seller's discretionary earnings is the business earnings before Interest, Depreciation, Taxes, Amortization and Owner's Compensation).
• Down payment Buyer has available $100,000
• SBA Loan $400,000  financed for 10 years @ 7% =  $4,644 per month payment which = $55,750 per year.
• Salary the Buyer needs from business to pay living expenses  $100,000.

Coverage Ration Calculation  

SDE                                       $175,000

Salary needed                         $100,000

Available for Debt Service      $75,000

Amount of Debt service          $55,750

Coverage ratio is                     1.35   Amount available for debt service divided by actual debt service.

Generally speaking when seeking an SBA Loan the coverage ratio required will be between 1.25 and 1.4.