Cash flow available for debt service

This is the top half of a coverage test: the cash a business earns that can go toward loan payments. The debt service coverage ratio divides it by the payments due. In a purchase, ask which of the target’s financial statements the figure is built from and how it is defined, because a different definition gives a different result.

Definitions in BDC’s guidance

BDC’s glossary calculates the debt service coverage ratio by dividing EBITDA by principal and interest. A BDC article on how banks assess a business gives a different rule of thumb: borrowing capacity is guided by net income plus depreciation, less the annual repayments of existing term debt. The same article says any profit a business earns is available to cover new debt service, and describes the debt-service coverage ratio using adjusted EBITDA, less current income taxes, distributions paid and unfunded capital expenditures.

What to ask

• Which definition the lender is using, in writing.
• Whether the lender adjusts the seller’s earnings before using them.
• Whether the owner’s own pay is deducted, since a new owner may need to be paid.
• Whether payments on existing debt are subtracted.