Business owners often add unrelated businesses expenses to their income/expense statement in an effort to reduce their taxable earnings. This reduces their net income significantly and difficulties arise when buyers of such businesses apply for financing from lenders, due to the low (or negative) debt-coverage ratio in the proposed deal.

The debt coverage ratio (DCR), which is calculated by dividing the gross cash flow (GCF) by the proposed annual debt service, is very subjective because of the way different banks define ‘gross cash flow’. The bank’s definition of cash flow differs from the traditional accounting definition as described in the FASB’s Statement of Financial Accounting Standards No. 95. Most banks calculate GCF as follows:
GCF= Normalized net income + non-cash charges + interest payments (net of taxes)

When performing a business valuation for use in underwriting, the bank will choose gross cash flow instead of net earnings as the dividend, since it will measure the borrower’s true ability to repay the debt, before taking into consideration the non-cash items such as depreciation and amortization. The key here is how the bank normalizes the net income. Typically referred to as recasting in lending lingo, this “cleansing process” can be detrimental to arriving at a GCF which will cover the proposed debt-service. The lender’s underwriters must follow certain guidelines when deciding what items can be normalized. The most important decision for the borrower in this case is to choose a lender which 1) understands that self-employed individuals will use commonplace tax strategies to mitigate tax payments, and 2) has normalization guidelines that are less stringent than other banks.

Most borrowers will just submit the seller’s financials to the banks, and rely solely on the business banker to normalize the numbers. These applications typically end up being rejected, since the business banker to which the application was submitted may not know the industry well enough to determine what items need normalization. Not only does the borrower have to initiate the process, the borrower must effectively support all of the ‘add backs’ with justifications. These financial adjustments should be used to convince lenders that the expenses need to be reevaluated and adjusted for abnormal compensation and unreasonable expenses. The most clear and concise way of supporting these adjustments is using the same methods a business appraiser would use- comparing the normalized financials of other companies in the same industry as a basis for the adjustments.

Another problem a borrower often encounters is when sellers are not willing to provide financials, or when they understate gross revenues when submitting their financials to their accountants. The latter is almost as detrimental as the former, because even after normalizing the net income based on abated revenues, the GCF may still come out to be too low.

Often when the banks see these types of tax returns, they advise the borrower to rescind the application and resubmit with no returns at all! Not only would this require creating a formal business plan with projections and assumptions, it would end up being costly and could take weeks to complete. Instead, using an actual YTD interim financial statement, the borrower could annualize the numbers, using the industry trends, and taking into consideration seasonal adjustments, with some normalization where applicable. Next, supportable projections based on the annualized figures would be created- the projections must be supported with industry trends, economic outlooks, and market comparable financials, all of which could be attained from business appraisal institutions and RMA Annual Statement Studies.

Gas stations, convenience stores, independent motels, and liquor stores are good examples of Tier 3 and Tier 4 businesses, being the riskiest and hardest to approve for financing (due to many of the reasons discussed above). Any of the businesses above, whether with or without property, have a chance of being financed if structured, packaged and underwritten creatively and efficiently. Additionally, the lenders to which the loan packages are submitted must be flexible in allowing add backs.

This article was written by Neal Patel, co-founder of Reliant Capital Funding, LLC. He can be reached at loans@reliantcf.com. The contents of this article are purely informational, and should not be deemed as legal or financial advice. Seeking assistance from professional advisors is strongly suggested prior to creating a loan package when requesting financing from a lender.