How Lenders Calculate Cash Flow and DSCR, Step by Step

The short version

A lender asks three questions of the numbers:

1. How much cash does the business really produce in a normal year? (Cash flow.)
2. Is that enough to pay the new loan and everything else the business owes, with room to spare? (Business DSCR.)
3. Is it still enough once the owner’s household is counted? (Global cash flow.)

You can run all three yourself in the acquisition and cash-flow calculator. This page explains what it is doing and why. The example below uses the calculator’s sample numbers, which are hypothetical.

Step 1: Start from the return, not the story

The starting point is net income from the tax return or the financial statements, usually for the most recent full year, with other years alongside it for trend. A lender uses documents, not the pitch, because it can only count what it can verify. If the return, the books and the seller’s description do not agree, expect questions before any math.

Step 2: Add back what is not really a cost of running the business

Some expenses on the return reduce profit without reducing cash, or will not continue after the deal. Lenders add them back:

• Interest. Old debt that is being paid off or replaced. The new loan’s payment is tested separately in Step 4, so counting both would double-count.
• Depreciation and amortization. Non-cash charges that lower net income without cash leaving the business.
• One-time or non-recurring items. A legal settlement, a moving cost, an unusual repair. Lenders look hard at these: if a “one-time” cost shows up every year, it is not one-time.
• Rent that goes away. If you are also buying the building the business rents, the rent disappears, and the loan on the building takes its place in the debt service.

Then they take out what the business has to spend to stay healthy:

• Maintenance capital spending that is not financed, such as replacing equipment as it wears out. A business that never replaces anything looks better on paper than it is.

Step 3: Pay the person running the business

If an owner works in the business, the cash flow must also support a realistic salary for that role. Many owners pay themselves too little, or take profit as distributions, which flatters the business’s coverage. A lender may deduct the pay the business needs to give whoever runs it.

Step 4: Test it against the debt payments

Add up the annual payments on the deal, its debt service: the new loan, and any seller note that is paying (a standby note is typically left out while it is on standby; see equity injection and seller notes). Some lenders test the payment at a higher rate than the one quoted, to leave room if rates move.

Business DSCR = business cash available ÷ annual debt service.

Step 5: Now add the household

The owner is also a person with a mortgage, a car payment and living costs, and usually guarantees the loan personally. Global cash flow counts the whole picture:

• Income: the cash flow before owner pay (it is what funds the owner’s draw), plus any other household income
• Less estimated personal taxes
• Less household living costs
• = cash available for all debt

divided by all debt payments: the deal’s debt service plus personal debt payments.

Business coverage was 1.83x. Global coverage is 1.28x. Lenders look at the lower of the two, which is why a strong business can still be a hard loan when the household is stretched. See the teaching case in what lenders look at.

Step 6: Ask what happens if it goes a little wrong

A coverage ratio that clears the minimum by a hair is fragile. Lenders want margin, and you should too. The same example, stressed:

The business holds up in every case. The household view is where the pressure shows: a 10% dip in cash flow takes global coverage below the 1.25x target used in this example, and a 20% dip takes it under 1.0x, which means the cash does not cover the payments. That is the kind of insight worth having before a lender raises it.

Where lenders push back

• Add-backs. The most common source of a lower number. Be ready to explain and document each one.
• Owner pay. Too low, and the lender substitutes its own number.
• Declining trend. A weak last year matters more than a strong earlier one.
• Cash versus accrual. A business on cash accounting can look different than one on accrual; expect reconciliation questions.
• Concentration. One customer, one contract or one supplier that could walk.
• Capital spending. A history of deferring maintenance.
• Personal debt. Business loans carried personally, a recent large mortgage, or a second home.

What to do with this

• Run your own numbers in the calculator. Change one thing at a time and watch which view moves.
• Fix the weak link, not the strong one. If global is lower, the levers are usually less debt, more cash in, a standby seller note, paying down personal debt, or a smaller deal.
• Get your documents in order before a lender sees the numbers: documents you will need.

If the numbers do not work today, that is advice, not a verdict. The most useful thing is to know why, and what would change the answer. Tell us what you are working on and we will walk through it.