Underwriting – How to Determine the Reasonability of Projections

Written By: John Milnes, CVA

(4 - 6 minute read)

As per the most recent SBA SOP[1], the historical cash flow for an existing business must demonstrate an adequate debt service coverage ratio (1.15x) after servicing the SBA loan.?Additionally, for cash flow projections, a lender must also calculate the debt service coverage and provide assumptions supporting the projected cash flow.?However, in many cases, borrowers will provide projections showing significantly stronger year-over-year sales growth, and/or significant improvement in earnings margins, compared to the historical financials of the operating business being purchased. Therefore, it is important to understand that a borrower’s projections should have some reliance on the historical financials of the operating business. When a buyer or seller provides projections that appear to be inconsistent with historical sales and earnings, it is important to ask the appropriate follow-up questions and for supporting documentation, including monthly income statements, comparative income statements from the prior year, and copies of contracts or lease agreements, if available.

Example #1 (Monthly Income Statements):

As seen in the example below, the company’s sales through June 30, 2024 were approximately $17.5MM, which annualizes to approximately $35MM, an increase of 13.4% over the prior year. However, the Company’s year-end sales projection is approximately $40MM, which reflects a 24% increase over the prior year.

In this case, it is important to obtain a monthly sales breakdown for the prior year to substantiate the sales projection provided, as shown below:

As shown above, the Company’s sales through June 30, 2023 were approximately $14.3MM compared to the current year sales of $17.5MM. This results in an increase in sales from the prior year in the same period of approximately 22.4% which is in line with the sales projection provided.?Therefore, the $40MM sales projection can reasonably be utilized within the underwriting process.

Example 2 (Comparative Income Statement)

Comparative income statements can also be helpful in not only substantiating sales projections, but expense projections as well. As seen in the example below, the Company’s sales were approximately $1.45MM through August 31, 2024, which annualized to approximately $2.1MM, a decrease of 3.5% from the prior year. Additionally, the historical?COGS margin was approximately 55% to 57%, while the COGS margin in the interim period was approximately 66.5%:

The Company’s projected 2024 sales were stated to be approximately $2.1MM and COGS were expected to be approximately 57%. Upon further analysis of the comparative income statement, the Company’s COGS margin through the prior year same period was approximately 68.5%. Accordingly, the Company’s projected COGS margin can reasonably be utilized. However, the Company’s sales through August 31, 2024 were 11.4% lower than the prior year same period.

Therefore, business at the Company appears to be seasonal with the Company incurring higher sales in the beginning of the year while also purchasing higher inventory. As a result, it is important to discuss with the borrower any potential seasonality with the business and any potential changes to operations that may assist with substantiating the provided sales projections.

Example 3 (Lease Agreements)

As shown in the example below, the Company’s historical rent expense fluctuated year to year:

As per discussions with the borrower, the fluctuations were attributed to rent payment deferrals worked out between the Company and the landlord. Therefore, it is important to obtain a copy of the Company’s lease agreement to confirm what the expected normalized lease rates are going forward to confirm the projected rent expense matches the lease agreement. In general, it is important to understand the reason behind any major expense fluctuations such as increases to the minimum wage or increases to the company’s insurance premiums, which can be verified with additional research or documentation.

Example 4: Contracts and Additional Documents

When analyzing project-based businesses, revenue projections can vary from the company’s historical performance due to the timing and size of projects. In these cases, it is important to obtain copies of contracts and backlog/pipeline reports, which detail the timeline of the project, the percentage of completion of various projects, and any projects that are expected to take place in the near future.

Conclusion

By analyzing a company’s historical performance, an underwriter can gain better insight into a company’s future projections which could help avoid any potential issues during the loan approval process. For further information regarding when a fair market valuation should rely on historical financials or projections, please read our article discussing the Capitalization of Earnings Method vs. Discounted Cash Flow Model.

[1] SBA SOP 50 10 7.1, pg. 109

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