Cash-flow lending sizes the loan based on the target business’s demonstrated ability to generate enough cash, after operating expenses, to service the debt going forward, rather than against the value of its receivables, inventory or fixed assets.
Because the collateral is thin or absent, the underwriting shifts entirely onto the numbers: “greater scrutiny of historical and projected financial statements, since the loan’s justification rests on those numbers holding up”, and lenders taking this approach “often want independent verification of those numbers before committing”. The loan agreement then carries “financial covenants tied to earnings metrics” that the buyer has to hold post-closing — not asset-value tests, because there is little asset value to test.
The metric that does the underwriting is the debt service coverage ratio, and market practice describes the point at which the base earnings figure itself changes: lenders “switch to EBITDA (profit independent of any owner); from roughly $1M up”. Below that line the base is typically owner-adjusted seller’s discretionary earnings (SDE); above it, EBITDA independent of any one owner.
This is the natural underwriting route for a target with little for an asset-based facility to secure — a professional-services or other people-and-contracts business, for example — where an asset-based lending tranche simply has nowhere to attach. Many Canadian acquisitions blend both: an ABL facility against whatever receivables and inventory exist, topped up by a cash-flow tranche sized against the earnings the asset facility cannot reach.
A target generates $1,100,000 of EBITDA — above the roughly $1M point where underwriting moves from SDE to EBITDA — and the lender is quoting an illustrative EBITDA-based coverage requirement of 1.30 times for a facility of this size. Maximum annual debt service the lender will underwrite is therefore $1,100,000 divided by 1.30, or $846,154. If the buyer’s proposed term loan would require $900,000 a year in principal and interest, it fails the test before a single asset is ever appraised — the fix is a smaller loan, a longer amortization, or more equity, not a different collateral package.
See also: asset-based lending, debt service coverage ratio and financial covenant.
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