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
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.