Purchasing a business requires multiple sources of capital. Typically, businesses are purchased through some combination that includes seller financing, subordinated debt, senior or bank debt, and equity. When deciding how much cash to put into the purchase versus how much to borrow, it’s important to use ratios. Below, some ratios are described to help guide your acquisition towards being appropriately structured.
Cash Flow Measurements:
Debt Service Coverage Ratio (DSCR) compares the business’ cash flow to its debt payments. A DSCR ratio of 1.20 is a common minimum target; the higher the debt service coverage ratio, the better.
Debt Service Coverage Ratio (DSCR) compares the business’ cash flow to its debt payments. A DSCR ratio of 1.20 is a common minimum target; the higher the debt service coverage ratio, the better.
Senior Debt to EBITDA implies how many years it would take to pay off debt balances if all cash flow generated by a business was used to pay down debt. In general, a ratio of less than 3x is considered acceptable; however, highly cyclical industries tend to have lower leverage tolerances. A ratio approaching 5 is considered high and is usually cause for concern.
Balance Sheet Measurements:
Current Ratio compares a company’s assets available in 12 months or less that are available to pay liabilities due in 12 months or less. A ratio higher than 1.25 is preferred. Additionally, lenders look at inventory history, as this ratio can be skewed higher by an entity that is carrying a lot of inventory.
Quick Ratio amends the current ratio by only comparing readily liquid current assets – eliminating assets such as inventory or advances to shareholders – and comparing the liquid assets to current liabilities. As a reference point, a ratio above 1.00 is preferred.
Debt to Tangible Net Worth illustrates how a business is funded. By comparing the amount of debt invested to a company’s tangible net worth, an investor (or lender) can compare who has more capital at risk. Different forms of capital – debt, equity, subordinated debt – have different expected returns. Newly acquired companies or companies that have acquisition histories have a higher debt to tangible net worth ratio.
Written by Aaron Schaffer
Chief Banking Officer at Community State Bank
aarons@csbemail.com
260.994.0450
February, 2024
Chief Banking Officer at Community State Bank
aarons@csbemail.com
260.994.0450
February, 2024