Why Profitability Does Not Always Mean a Business Can Support Its Debt

Most business owners understand the basic structure of a profit-and-loss statement. They know how to estimate revenue, subtract operating expenses and determine whether the business is expected to earn a profit.

That is an important starting point, but an income statement alone does not tell a lender whether the business will generate enough cash to support the proposed debt.

A complete forecast requires three statements

A complete financial model normally includes a projected income statement, balance sheet and cash flow statement. Building all three statements and connecting them properly requires more financial skill than preparing a stand-alone profit-and-loss projection, but each statement answers a different question.

The income statement shows whether the business is expected to be profitable.

The balance sheet shows what the business owns and owes, including cash, receivables, inventory, fixed assets, loans and owner equity.

The cash flow statement explains how operating results and changes in the balance sheet affect the company’s actual cash position.

Together, the three statements allow a lender to evaluate profitability, liquidity, leverage and repayment capacity. An income statement by itself cannot provide that complete picture.

Income does not always equal cash

A company can report a profit and still experience a cash shortage.

If customers take 45 or 60 days to pay, revenue may appear on the income statement well before the cash is collected. A growing company may also use substantial cash to purchase inventory or carry larger receivable balances.

Other items create the opposite effect. Depreciation reduces reported income without requiring a current cash payment, while loan principal payments use cash but do not appear as an expense on the income statement.

A business can therefore show positive net income while its available cash is declining.

What lenders are trying to determine

When evaluating a loan, the lender needs to know whether the business is expected to generate enough cash to make its required principal and interest payments.

One of the most common measures is the debt-service coverage ratio, or DSCR. Although the precise calculation varies, DSCR generally compares cash flow available for debt service with scheduled principal and interest payments.

A DSCR of 1.00 means projected cash flow is equal to scheduled debt service, leaving no cushion for weaker sales, higher expenses or unexpected costs. A ratio above 1.00 provides some margin, although the required level will depend on the lender and the transaction.

This is why a profitable business may not qualify for the amount of debt it is requesting. Its earnings may be tied up in working capital, its principal payments may be too high or its projected cash flow may provide too little room for normal business volatility.

The important question is not simply whether the company expects to report a profit. It is whether the company will have sufficient cash, at the right times, to operate normally and meet its debt obligations.