A lender quality of earnings report presents three earnings figures for each period: reported EBITDA, EBITDA after the adjustments management or the broker proposed, and EBITDA after the adjustments diligence can actually support. Only the third figure goes into the debt service coverage calculation under SOP 50 10 8.1. In the illustrative example below, management proposed $1,205,000 of adjusted EBITDA for the trailing twelve months and diligence supported $1,010,000. On the last fiscal year, the basis the SOP allows the lender to use, that $211,000 difference moved debt service coverage from 1.47x to 1.20x, below the 1.25x the SOP requires, and the loan had to be restructured before it could close. Every line is identified and supported on its own, which is what the SOP requires and what a credit officer needs to see.
Project Cedar is an illustrative $6.0 million acquisition of a residential HVAC service company with about $7 million of revenue, owner operated, cash basis books. The seller's broker presented trailing twelve month adjusted EBITDA of $1.2 million and priced the business at 5.0x that figure, which is in line with what residential HVAC companies of this size have been trading for. The buyer's proposed structure was a $4.8 million SBA 7(a) loan, a $600,000 seller note, and a $600,000 equity injection. The lender engaged Credex for the SOP 50 10 8.1 quality of earnings with cash proof. The figures are illustrative and rounded to thousands.
DA-01, owner compensation. The seller paid himself $275,000 and management added back $130,000 to reset it to a $145,000 "market" salary. The buyer will need a general manager to run the business, and the market rate for that role at this size of company is closer to $180,000. The add back is accepted, but at the corrected benchmark, which reduces it by $35,000 a year. This is the most common place a lender QoE and a broker's package diverge.
DA-02, personal expenses. Management identified $55,000 of vehicles, travel, and household expenses run through the business. Receipts and bank detail supported about 60 percent of that. The unsupported balance is not added back. An add back that cannot be traced to a document is not an add back.
DA-03, the legal settlement. The seller treated a $60,000 settlement as a one time item. The general ledger and the cash proof showed similar payments in each of the last three years, all relating to warranty claims on installed systems. That is a recurring cost of doing business and it stays in the earnings.
DA-04, cash to accrual. The books are kept on a cash basis. Customer deposits collected in December for installations completed in January were counted as December revenue. The SOP requires the earnings to be restated on an accrual basis, so revenue is moved to the period in which the work was done. The effect is small in each year but it also reveals how much of the year end is driven by timing.
DA-05, deferred maintenance. The business runs twelve service vans that average nine years old, and the seller has replaced none of them in three years. Keeping a fleet that size at a normal age means replacing about two vans a year, roughly $100,000 of recurring spend that the reported earnings do not carry. The SOP names deferred maintenance and capital expenditures as a required adjustment category, and this is why.
DA-06, unreported deposits. The cash proof matched customer payments to bank deposits and found that a set of customer checks each year had been deposited to an account that was not in the books. The deposits were traced to invoices and confirmed as revenue. This adjustment increases earnings. A cash proof works in both directions; it is not only a search for problems.
The SOP requires the lender to use the earnings figure from the QoE in the debt service coverage calculation, on the last fiscal year or the average of the last two fiscal years, and to retain the report in the credit file. On the structure the buyer proposed, annual debt service on the $4.8 million loan is about $777,000, with the seller note on full standby.
On the broker's number the deal has room to spare. On the number diligence could support, coverage is below the 1.25x minimum for an Initial Acquisition on both bases the SOP permits. The trailing twelve months look better, but the SOP does not allow the lender to use them. The deal as proposed does not meet the SOP.
The multiple tells the same story from the other side. The buyer believed he was paying 5.0x earnings. On the earnings that can be proven to the bank, he was paying 5.9x, at the top of the range for an owner operated HVAC company with an aging fleet and no maintenance agreement base. The price did not change. What changed was the knowledge of what the price was buying.
Project Cedar closed. The seller agreed to increase the standby seller note to $900,000, the 7(a) loan was reduced to $4.5 million, and debt service fell to about $729,000. On the diligence adjusted earnings, that produced 1.28x on the last fiscal year, above the floor, with 1.39x on the trailing twelve months as a reference, and the lender's file shows how each figure was reached.
The $211,000 that separated the broker's number from the supported number in the last fiscal year was not one error. It was six items, each reasonable looking on its own, each with a plausible explanation from the seller, and each of which required a different procedure to test: a compensation benchmark, receipt tracing, a three year general ledger review, a cut off analysis, a fleet age schedule, and a bank to book cash proof. A lender reviewing the broker's package would not have found any of them, because the package presents a total, not the items behind it. A lender reviewing the tax returns would not have found them either, because the returns report what the seller filed, not what the business earned.
Without the analysis, the lender would have booked a $4.8 million loan at 1.47x coverage that was actually at 1.20x, below its own credit policy and below the SOP, with a borrower who had put in the minimum equity and had no cushion for the first slow winter. The guaranty would have been exposed to a coverage error on day one. With the analysis, the lender restructured the loan before closing, the buyer went in knowing what he had bought, and the seller carried more of the risk on the earnings he had represented. This is why the SBA requires the lender, not the borrower, to engage the QoE, and why it requires each adjustment to be identified and supported on its own rather than netted into one number.
The schedule above appears on the first page of the Credex report, followed by a one line description and the supporting document reference for each adjustment. The credit memo insert states the diligence adjusted figures on both the last fiscal year and the two year average basis in the lender's own DSC template, and confirms the five items an SBA reviewer checks: purchase price above the threshold, engaged by the lender, three period cash proof, every add back individually supported, and the QoE figure used in the DSC.
Because the SOP does not allow it, and because in this example it would have produced a loan that did not meet the lender's own coverage requirement. The report must be prepared for the lender by an independent professional, and the lender must use that report's earnings, not the seller's or the broker's, in the coverage calculation.
No. Unreported deposits, expenses that belong to the owner personally, and one time costs the seller forgot to add back all increase earnings. In most owner operated businesses the net effect is a reduction, but the report shows both directions.
Credex delivers the full lender QoE, including this schedule, the three period cash proof, and the credit memo insert, in ten business days from complete seller documents. Most providers quote three to four weeks.