A healthy DSCR at closing hides how little revenue the business can lose, because fixed costs stay put when sales fall.
Divide the cash cushion above debt service by the contribution margin: maximum revenue fall = (cash flow available for debt service − debt service) ÷ (contribution margin × revenue). On an illustrative $2.4m business bought with a $1.44m SBA loan, a comfortable-looking 1.55x DSCR survives a revenue fall of only 14.1 per cent before cash flow no longer covers the $233,168 of annual payments, and only 7.7 per cent before it drops below 1.25x.
Worked in full in Buying a Small Business by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Buyers look at the DSCR at closing and feel safe. The question that matters in year one is different: how much business can be lost before the loan payment comes out of savings. The answer is always smaller than it looks, because costs do not fall with revenue. That is operating leverage, and it works against the buyer in a downturn.
| Input | Value |
|---|---|
| Revenue | 2,400,000 |
| Variable costs (materials, direct labour, commissions) | 62% of revenue |
| Contribution margin | 38% |
| Fixed costs, including a 100,000 market salary for the owner | 520,000 |
| Maintenance capex | 30,000 |
| Purchase price | 1,600,000 |
| SBA 7(a) loan, 10 years, 10.5%, monthly payments | 1,440,000 |
Monthly payment: =PMT(0.105/12, 120, -1440000) = 19,431, or 233,168 a year.
Contribution = 2,400,000 × 38% = 912,000. EBITDA = 912,000 − 520,000 = 392,000 (a 16.3 per cent margin).
Cash flow available for debt service = 392,000 − 30,000 capex = 362,000. DSCR = 362,000 ÷ 233,168 = 1.55x.
The payment calculation itself is set out in the monthly payment on an SBA loan. A 1.55x ratio clears the 1.25x most lenders underwrite to with room to spare, and that is where the comfort comes from.
Each dollar of revenue lost takes 38 cents of cash flow with it, because the 62 cents of variable cost goes away but the fixed costs do not. Work back from the cash flow you need.
Required revenue = (target DSCR × debt service + capex + fixed costs) ÷ contribution margin
At 1.00x: (233,168 + 30,000 + 520,000) ÷ 38% = 783,168 ÷ 0.38 = 2,060,968, a fall of 339,032 or 14.1%.
At 1.25x: (291,460 + 30,000 + 520,000) ÷ 0.38 = 841,460 ÷ 0.38 = 2,214,367, a fall of 185,633 or 7.7%.
Shortcut: cushion ÷ contribution per dollar = (362,000 − 233,168) ÷ 0.38 = 128,832 ÷ 0.38 = 339,032.
| Revenue fall | Revenue | EBITDA | EBITDA fall | DSCR |
|---|---|---|---|---|
| 0% | 2,400,000 | 392,000 | 0% | 1.55x |
| 5% | 2,280,000 | 346,400 | 12% | 1.36x |
| 10% | 2,160,000 | 300,800 | 23% | 1.16x |
| 15% | 2,040,000 | 255,200 | 35% | 0.97x |
| 20% | 1,920,000 | 209,600 | 47% | 0.77x |
Every point of revenue lost costs about 2.33 points of EBITDA here, the ratio of contribution (912,000) to EBITDA (392,000). A 15 per cent revenue fall, which one lost customer or one bad season can produce, takes EBITDA down by 35 per cent and the DSCR below 1.0x.
Holding starting revenue and EBITDA constant, the split between fixed and variable costs decides the cushion.
| Contribution margin | Fixed costs | Fall to 1.25x | Fall to 1.00x |
|---|---|---|---|
| 30% | 328,000 | 9.8% | 17.9% |
| 38% | 520,000 | 7.7% | 14.1% |
| 50% | 808,000 | 5.9% | 10.7% |
The high-margin business is the fragile one. A software-like or professional services business with 50 per cent contribution and heavy salaried staff can absorb only a 10.7 per cent revenue fall; a distributor with thin margins and mostly variable costs can absorb 17.9 per cent on the same EBITDA and the same loan.
The lever the buyer controls is fixed cost. If the owner can cut their own salary from 100,000 to 40,000 in a bad year, fixed costs fall to 460,000 and the break-even fall widens from 14.1 to 20.7 per cent. That is why a buyer's personal savings and spending matter to the lender as much as the business's ratios do; how much the owner can draw in a normal year is covered in how much you can pay yourself after an SBA acquisition.
Assuming EBITDA falls in line with revenue. On that reading a 14.1 per cent revenue fall cuts EBITDA by 14.1 per cent, cash flow to 306,625 and the DSCR to a still-healthy 1.32x. In fact EBITDA falls by 32.9 per cent and the DSCR to exactly 1.00x. The proportional shortcut overstates the cushion more than twofold, and it is the shortcut most broker packages and many first-time buyer models use.
Before signing: ask the seller for the worst revenue year in the last decade and run it through this formula, not through the DSCR. If that year would have put the business below 1.00x, the deal needs more equity, a seller note on standby, or a lower price.
A 1.55x DSCR is a revenue cushion of only 14.1 per cent when 38 cents of each lost dollar is lost cash flow. Compute the break-even revenue, not just the ratio, and stress it against the cost structure the business actually has. The book's two acquisition models run the same test year by year, and the companion page describes a deal the bank approved at 1.56 times that covered its own debt 0.96 times in its first year; both are in the free workbook for this case. A blank version is in the small business acquisition model.
The payment still falls due, and the borrower's personal guarantee means it comes from personal funds. In the illustrative case a 15 per cent revenue fall takes the DSCR to 0.97x, a shortfall the owner must fund each month, often by cutting their own salary before the loan is in default.
Because fixed costs do not fall with sales. With a 38 per cent contribution margin and 520,000 of fixed costs, each point of revenue lost removes about 2.33 points of EBITDA: a 10 per cent revenue fall cuts EBITDA by 23 per cent, from 392,000 to 300,800.
It is a common underwriting minimum, but it is a small cushion. A business on this cost structure that starts at exactly 1.25x has 58,292 of cash flow above its payments, which a revenue fall of 153,400, or 6.9 per cent, wipes out. Even at 1.55x, a 14.1 per cent fall takes the business to 1.00x.
This article is one calculation from Buying a Small Business. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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