Ask the Experts : 504 Q & A

Q - When utilizing the financial data provided by the small business, how is repayment ability evaluated?

Historical earnings and cash flow are the best basis upon which to gauge repayment ability. Projections are to be considered the basis for determining repayment when there is a change in the circumstances affecting the business (adding an additional product line, significantly expanding its workforce, etc.) or a lack of historical financial data (start-up business or change in ownership).

Regardless of whether historical or projected performance is the basis for repayment, all expenses (e.g., operating expenses, owners withdrawals, salaries, dividends, etc.) must be considered when evaluating repayment ability.

(1) Historical Cash Flow

The best evidence of repayment ability is sufficient cash flow from prior operations to retire the anticipated annual fixed obligations of the business. It is important to note any trends in revenues and cash flows.

Interim operating statements may not be a reliable basis for loan approvals, particularly where the interim results are inconsistent with the prior operating results (as seen when evaluating the corporate tax returns). Interim statements for seasonal businesses can be especially misleading.

Thus, when evaluated on a historical basis, the last full operating year and the interim period must demonstrate repayment ability or the small business is required to provide realistic projections that demonstrate the availability of markets and stability of sales.

(2) Projected Cash Flow

If historical cash flow does not demonstrate repayment ability, a realistic projection of future earnings must be used. The projections must be tested against industry averages and historical operations to assess feasibility. The small business owner must explain any significant variations.

If the business is a new business or a start-up (operations less than 2 years), the small business owner must provide enough information to show that it understands the nature of the industry. This is typically provided by the borrower, in the case of a start-up, through the submission of a business plan. The loan specialist must then analyze the borrower's proposal as to whether it is a reasonable and appropriate undertaking for the business. The loan specialist must also assess the management ability of the business. In doing this, it must consider education, experience, motivation, and stability.

What does the loan specialist typically evaluate when determining the ability of the small business to repay the loan with earnings from the business?

The ability to repay a loan from the cash flow of the business is the most important consideration in SBA's loan making process.

Existing Debt:
The pro forma schedule of annual fixed obligations (debt) is a very important element in analyzing the ability to repay. Annual fixed obligations, including the proposed loan, are generally shown as the total principal obligation of term debt.

Compensation of Owners/Principals:
The loan specialist also considers the effect that owner compensation may have on repayment ability. As such, a global cash flow analysis is often utilized to adequate determine the repayment ability of the small business. Typically global cash flow analysis includes the following questions:
(a) What personal obligations and expenses does each owner have?
(b) How much compensation, including bonuses, perks, and benefits, is the business really paying each owner?
(c) Are company "assets" benefiting the company or any owner?
(d) How do these practices impact the cash flow and repayment ability?
(e) Do the balance sheets show increases in "Loan(s) Receivable-Officer(s) or Partner(s)" accounts? Increases in these accounts usually indicate funds being paid to the officers/partners in addition to their normal compensation listed on the income statement for that year. This conceals the impact on net profits and net worth and causes the traditional “rule of thumb” cash flow calculation to be inflated.

Source of the Cash Flow:

The presence of a positive actual cash flow is not necessarily an indication of repayment ability. If the source of the cash flow is mostly or entirely from the occurrence of debt, equity injection or sale of company assets, repayment ability may not exist.

If the business does not demonstrate sufficient repayment ability, but the project appears to have substantial collateral, can a SBA 504 loan be granted to the small business?

No. All SBA loans must be of such sound value or so secured as to reasonably assure repayment. Sound value contemplates such factors as good character, earnings, collateral, management ability and financial condition. The object is not to obtain sufficient collateral to completely liquidate loans under future conditions.

The SBA does not make loans based upon the liquidation value of collateral. This would be a disservice to the borrower. If there is not sufficient evidence indicating that the firm can repay the loan from the cash flow of its operations, the loan application must be declined.

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