Many times, new loan officers or even credit managers new to 504 lending tell me that a business’ Debt Service Coverage doesn’t meet SBA’s requirements. They’re often concerned that the lender’s credit memo says that the business’ cash flow will be 0.95X. In those cases, we have a little chat about SBA’s requirements for DSC. It goes like this:
ME. Here’s some background that might be helpful in understanding 504 cash flow requirements: Because of the economic development objectives and community benefits that expanding businesses offer our economy, SBA takes a more expansive view of debt service coverage for 504 loans. Now, I understand that no one wants to be known as a “liberal lender,” but the trick is for an economic development lender like you to make a loan without adhering to a liberal lending policy.
LENDER. OK. So just how much debt service coverage does SBA require?
ME. Well the agency doesn’t impose one ratio that fits all. The applicant’s debt service coverage ratio (operating cash flow divided by debt service) must be equal to or greater than 1:1 based on calculations acceptable to SLPC. (SOP 50 10 7 pg. 297; SOP 50 10 6 pg. 477)
Hold on though, There’s no need to abandon all hope if you don’t have 1:1 coverage. Instead, if the historical cash flow doesn’t show sufficient pro forma debt service coverage, SBA allows ─even requires─ the CDC to analyze projections and provide the supporting assumptions. And if even then you cannot show 1:1 coverage in Year 1 of operations but you can show it in year 2, you are required by the SOP to demonstrate sufficient liquidity to cover the shortfall in Year 1.
LENDER. How do I show sufficient liquidity to cover the shortfall? Do I have to show that the applicant will have enough unencumbered cash in two years?
ME. There’s no real trick to it. Here’s the procedure I use to show sufficient liquidity:
The situation. When financing a startup, SBA requires a monthly cash flow analysis for the first 12 months of operations or for three months of operations beyond the breakeven point (whichever is longer). Let’s say that having obtained a cash flow analysis for 12 months, I notice a cash flow shortfall.
That means the business cash flow analysis demonstrates that the borrower cannot make payments, which isn’t a good thing to show in a credit memo. After all, payments still must be made and most likely the business owner will cover them. But the owner doesn’t have to cover 100% of the payments: Just the shortfall. The cash flow analysis the borrower prepared shows how much the shortfall will be for each month until breakeven.
My solution. I add all the shortfalls together, check the liquidity of the principal─and voila! If it’s sufficient to cover the shortfall, I have complied with SBA’s requirement to demonstrate sufficient liquidity to cover the shortfall in Year 1. Then I hurry to complete the T’s and C’s (Terms and Conditions), submit the application thru ETRAN and wait patiently for the SBA loan number that’s sure to come.
Richard Jeffrey
Senior Associate, CDC/504 Program
richard@jrbrunoassoc.com
www.jrbrunoassoc.com