Financing

How Much Can You Borrow to Buy a Funeral Home?

The price of a funeral home and the amount you can borrow are closely linked.

The payments for a business loan come out of the cash flow of the business. To make these payments, the business has to produce enough revenue to pay its expenses, pay a salary to the owner, and have enough earnings left over to make the monthly loan payment.

Thus the price that you pay for a funeral home is a function of how much you can borrow. And how much you can borrow is a function of how much cash the business produces each month.

To explore the link between cash flow and the size of your loan, let’s make some assumptions about the buyer/borrower:

  • The buyer will obtain bank financing to make the purchase of the funeral home.
  • The buyer has excellent credit, strong industry experience and the ability to make a modest down payment.
  • Any seller financing will be at similar rates and terms as the bank financing.
  • The buyer will own and operate the business for profit as a stand-alone facility.
  • The value of the individual assets of the business, including real estate, are not greater than the overall value of the business.

Seller’s Discretionary Earnings

In the funeral industry most businesses sell in a price range between four to six times Seller’s Discretionary Earnings (SDE). This price range typically includes all operating assets of the business. SDE or cash flow available to the owner is also expressed in terms like adjusted cash flow and adjusted EBITDA (earnings before interest, taxes, depreciation and amortization).

Cash flow for debt service (CDS)

Since most buyers are in business to make money, it makes sense to determine how much cash will be available to pay debt service after the purchase. This is also the method used by banks to determine how much they can loan on a purchase.

Cash flow available to service debt is always a lower number than SDE. It is calculated by subtracting a normal salary for the borrower from SDE. Most lenders require a borrower to budget the minimum salary needed to take care of his or her personal liabilities and living expenses. They also require a small margin of safety over and above the actual debt service requirement which I will explain shortly.

The minimum salary required by the borrower will vary depending on their personal debt level. A good rule of thumb to budget and estimate a borrower’s personal salary requirement is to multiply their annual personal liabilities by two. For example, a borrower with annual personal liabilities of $15,000 will require a minimum personal salary of $30,000, which is then subtracted from SDE to arrive at cash flow available for debt service. Cash flow available for debt service or CDS is then used to determine how much the borrower can actually borrower for the purchase, which then allows the borrower to estimate how much they can offer the seller.

The bank’s Debt Coverage Ratio

In addition to subtracting a salary requirement, most banks will also build in a margin of safety when calculating the actual debt payments they are comfortable with. This margin of safety is referred to as debt coverage and is usually expressed in a ratio called the debt coverage ratio. Some banks require a minimum debt coverage ratio of at least 1.25 and some up to 1.50. For example, if a bank required a minimum debt coverage ratio of 1.25 and the CDS was $125,000, the bank would only be comfortable with annual debt payments up to $100,000. This total would then be used with the amortization term and interest rate to determine how much the borrower could actually borrow for the purchase.

An example

The following example will help illustrate both the minimum salary requirement and the debt coverage margin. Let us say over the past three years a business has achieved average SDE of $350,000. The borrower’s personal salary requirement is estimated to be at least $50,000, which is then subtracted from SDE to arrive at CDS of $300,000. Let us say the lender is conservative and requires debt coverage of at least 1.5 on loans of this size. Dividing CDS of $300,000 by the minimum debt coverage ratio of 1.5 leaves $200,000 for total annual debt payments. In this example, $200,000 in annual debt payments over 15 years at 8.00% would allow the buyer to borrower approximately $1.7 million to make the purchase. If the buyer planned to put down $300,000 in cash, the buyer could offer the seller approximately $2.0 million for the business.

This example shows clearly that the buyer is unlikely to offer the seller more than $2M for the funeral home because the business can’t service more than $200,000 in loan payments each year.

Now that you know how to calculate the amount of the loan you are seeking, let’s look at the sources of financing and the process for getting a loan.

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